The nonlinear relation between financing decisions and option compensation

Abstract

Recent studies argue that CEO option compensation affects executives’ behavior toward risk. Specifically, the literature provides seemingly conflicting evidence regarding the impact of equity compensation (particularly option holding) on financing activities. We propose and test a nonlinear (e.g., inverted U-shaped) relation between corporate borrowing and option compensation. Consistent with our hypothesis, we empirically show that, in the low range of the option vega, a firm’s debt ratio increases as the option vega increases. However, in the high range of the option vega, we find the opposite relation. Our explanation is based on the contrasting effects of option compensation on managerial incentives toward risk. The positive wealth effect on leverage arises from the convexity of the option compensation, while a negative risk-premium effect exists due to managerial risk aversion. This reconciles the conflicting relation between leverage and option compensation that is often observed in the literature.