Option Incentive Research Articles

Powerful CEOs and Stock Price Crash Risk

We find that firms with powerful CEOs lead to stock price crash. The effects of earnings management, tax avoidance, CFO option incentives and CEO overconfidence on crash are more pronounced for firms with powerful CEOs. The effect of CEO pay slice on crash risk is more pronounced for firms with powerful founder CEOs. The takeover index, a proxy for corporate governance, mitigates stock price crash for firms with non-powerful CEOs. Product market competition does not attenuate the impact of CEO power on crash. Our findings provide new insights on the importance of CEO power in driving stock price crash risk.

Option incentives, leverage, and risk-taking

While there is extensive research on how option incentives in executive compensation relate to risk-taking by managers, the impact of capital structure on this relationship has received little empirical attention. Extant work suggests that heightened managerial career concerns arising from financial risk and monitoring by debt holders will result in leverage dampening the relationship between managerial risk-taking and equity-linked incentives. We empirically evaluate this contention and find that firm leverage is associated with a significant weakening of the positive relationship between option incentives in flow compensation and managerial risk-taking. This result holds after accounting for the endogeneity of the firm leverage and incentive compensation decisions, and is robust across alternative measures of managerial risk-taking and to using the firm's credit ratings instead of leverage. The attenuating effect of firm leverage arises from both the long-term and short-term components of debt and is significantly stronger during the financial crisis of 2007–2009. Overall, the evidence highlights the influence of capital structure on the relationship between option incentives and managerial risk-taking.

Are more able CEOs getting more compensated? Evidence from the pay-for-performance sensitivity of equity-based incentives

This study investigates whether the managerial ability of a chief executive officer (CEO) is associated with the CEO's pay-for-performance sensitivity (PPS) of the equity-based compensation. We predict that more talented CEOs receive a higher PPS of equity incentives. Using the managerial ability score (Demerjian, Lev, & McVay, 2012) and PPS measures of options and stocks (Core & Guay, 1999), we find that a CEO's PPS of the equity-based compensation is significantly increasing in the CEO's ability. We also find that the association between managerial ability and the PPS of stock incentives is more evident for small firms. Furthermore, our results show that high ability CEOs are associated with a steeper PPS of option incentives, especially when they are not near retirement. Together, our findings suggest that firms generally incorporate the relative efficiency factor of CEO's ability in designing the CEO's equity-based compensation contracts, and thus the cross-sectional variation in the CEO's PPS is positively influenced by the CEO's ability.Data availability: Data used in this study are available from public sources identified in the study.

Agency costs, executive incentives and corporate financial decisions

This paper investigates the roles of executive incentive structures in creating and mitigating investment-related agency costs. A model is developed which shows that underinvestment and overpayment of dividends are always expected to prevail when managers are offered short-term incentives, while overinvestment and underpayment of dividends are likely to exist when managers are offered long-term incentives. Using a large sample of non-financial US-listed firms over the period 1992–2009, it is found that managers underinvest and overpay dividends when offered vested stocks, but overinvest and underpay dividends when offered option incentives. An increase in these incentives, however, mitigates these problems. The results also suggest that, if properly constructed, long-term incentives might be superior to short-term incentives, and should be used alone in designing the optimal incentive package under certain conditions.

Corporate Governance and Firm‐specific Stock Price Crashes

AbstractWe investigate whether ownership structure, accounting opacity, board structure & processes and managerial incentives attributes relate to future stock price crash risk. Principal component analysis on the 21 attributes that comprise these four corporate governance dimensions reveals that they can explain between 13.1% and 23.0% of a one standard deviation in crash risk. Transient institutional ownership, CEO stock option incentives and the proportion of directors that hold equity increase crash risk, whilst insiders' ownership, accounting conservatism, board size and the presence of a corporate governance policy mitigate crash risk. Overall these relationships are more pronounced in environments that accentuate agency risk.

Executive Compensation And Ownership Structure

The objective of this paper is to highlight the impact of ownership discrepancy and type (managers, families, institutions) on executive compensation.Basedon a sample of French listed firms and using panel data regressions, the results show that capital concentration (Jensen 1986) negatively affects both the level of total executive compensation and the probability of use of stock option incentive plans. This confirms our theoretical alignment hypothesis. Moreover, the results show no evidence of the existence of a significant effect of ownership discrepancy on managerial compensation.Institutional shareholders are likely to encourage the use of stock option incentive plans and managerial ownership positively and significantly influences the level of total and fixed compensation. Family shareholding negatively affects executive compensation variables.

ROBUST PORTFOLIOS AND WEAK INCENTIVES IN LONG-RUN INVESTMENTS

When the planning horizon is long, and the safe asset grows indefinitely, isoelastic portfolios are nearly optimal for investors who are close to isoelastic for high wealth, and not too risk averse for low wealth. We prove this result in a general arbitrage-free, frictionless, semimartingale model. As a consequence, optimal portfolios are robust to the perturbations in preferences induced by common option compensation schemes, and such incentives are weaker when their horizon is longer. Robust option incentives are possible, but require several, arbitrarily large exercise prices, and are not always convex.

An Empirical Investigation on CEOs' Option Incentives and Firmss Risky Financing Policy: Evidence from Australian Public Companies

In order to align executives’ interests with shareholders’ interests, board of directors has rewarded executives with more option-based payments in the past decades. However, as volatility of share return increases, CEOs are more risk averse because their human capital and wealth are undiversified. Consequently, CEOs may pass up risky but value-enhancing corporate policy decisions. High pay-equity risk sensitivity (vega) CEOs are hypothesised to have more incentive to adopt more risky corporate policy, given that the volatility of the underlying share increases option value in Black-Scholes option pricing model.This study investigates the effect of vega on firm’s book leverage and vega determinants based on a panel data of 137 Australian firms from 2003 to 2012, a period in which the federal government implemented a series of executive pay reforms to tie the pay more closely to performance. The results show that vega has a significant and positive effect on firm’s leverage. In addition, the results demonstrate that there is a negative and statistical significant association between vega and CEOs’ risk-aversion such as the option moneyness and cash compensation. This study also provides evidence that firm size has a significantly positive effect on firms’ debt financing. Furthermore, in-the-money options and executive cash compensation have significant and negative impact on vega.

Option Incentives, Leverage, and Risk-Taking

Option Incentives, Leverage, and Risk-Taking

The Readability of 10-K Reports and Stock Price Crash Risk

This paper shows that less readable 10-K reports predict higher stock price crash risk. Using stock price crash risk or, more generally, the third moment of stock return distribution as a powerful indicator of managerial bad news hoarding, our results strongly support the prediction that managers can successfully hide adverse information and boost current stock prices by writing more complex financial reports. Additional analyses show that the effect of financial reporting complexity on crash risk is more pronounced for firms with (persistent) negative earnings news or with transitory positive earnings news, for firms with greater CEO stock option incentive, and for firms with lower litigation risk. We also find that the passage of the Sarbanes–Oxley Act (SOX) does not mitigate the relation between financial reporting complexity and crash risk. Moreover, it appears that textual obfuscation is more significant than earnings management in determining crash risk in the post-SOX era. Finally, firms with less readable financial reports experience sharper price drops during the 2007–2008 financial crisis.

Option repricing, management turnover and restatement

This study examines the association between financial restatements and executive option repricings and tests whether stock option repricing reduces management turnover in restating firms. We found a positive association between financial restatement and management turnover and those financial restating firms are likely to implement option repricing when the manager’s equity compensation is large and the sensitivity of the option value is high. However, we found no evidence that executive option repricing reduces management turnover in financial restating firms. Our analysis showed that, although financial restating firms may implement option repricing to restore the option incentive effect, valuable managers often leave their jobs because of poor future prospects in restating firms. Our results, therefore, suggest that repricing of executive stock options is not an effective management retention strategy for financial restating firms but managers’ equity compensation and option value incentives are important determinants of option repricing.

Robust Portfolios and Weak Incentives in Long Run Investments

When the planning horizon is long, and the safe asset grows indefinitely, iso-elastic portfolios are nearly optimal for investors who are close to iso-elastic for high wealth, and not too risk averse for low wealth. We prove this result in a general arbitrage-free, frictionless, semi-martingale model. As a consequence, optimal portfolios are robust to the perturbations in preferences induced by common option compensation schemes, and such incentives are weaker when their horizon is longer. Robust option incentives are possible, but require several arbitrarily large exercise prices, and are not always convex.

The effects of option incentives on research and development investment

This paper examines how various elements of CEOs’ option portfolios create conflicting incentives on research and development investment decisions. Incentives from unexercised vested options are shown to have an increasing effect on R&D investment, whereas the effect of incentives from unexercised unvested options is non-monotonic. In particular, R&D investment initially increases with incentives from unvested options and then decreases afterwards. Similarly, newly granted options have a non-monotonic effect when CEOs do not retain any unvested options in their portfolios. However, for an average firm where unvested options have been accumulated at a high level, adding new granted options only has a decreasing effect on R&D. The effects of various option elements on R&D investment can be explained by a combination of an incentive alignment effect and a risk diversification effect.

Australian evidence on CEO option grants

We test the option incentive models of Hall and Murphy (2000, 2002) and Choe (2003). Hall and Murphy (2000, 2002) posit optimal grant size and exercise price contingent on the executive’s levels of risk aversion and private diversification. Choe (2003) relates these choices to firm characteristics, principally the target risk level and financial leverage. A unique hand-collected data set of Australian grants is employed, wherein exercises prices and grant sizes are unconstrained by taxation and accounting practices. The Hall and Murphy (2000, 2002) model is found to explain observed exercise prices while neither model satisfactorily explains grant sizes. However, there is some evidence that CEO influence is associated with larger grants than posited by these optimal incentive models, but does not impact on exercise prices.

Corporate Governance and Stock Price Crashes

We investigate whether four dimensions of corporate governance mechanisms, namely ownership structure, accounting opacity, board structure and process and managerial incentives, relate to 1-year-ahead stock price crash risk. Employing principal component analysis on the 21 attributes that comprise these four categories, we find that corporate governance explains overall between 13.1% and 23.0% of a one standard deviation in future crash risk. Further analysis reveals that transient institutional ownership, CEO stock option incentives and the percentage of directors that hold equity in the firm increase a firm’s future stock price crash, whilst insiders’ ownership, conditional accounting conservatism, board size and the presence of a corporate governance policy have the ability to mitigate crashes. The relations between these governance attributes and future crash risk are more pronounced in environments that accentuate agency risk. Our findings support the notion that sound corporate governance systems curb opportunistic behavior of managers to hide and accumulate bad news from outsiders.

Executive Stock Options and Manipulated Stock‐Price Performance

AbstractPrevious studies have examined the manipulation of executive stock option awards and exercises, focusing on information timing by managers. In this paper, we investigate managerial manipulation of stock‐price performance motivated by stock options. To distinguish performance manipulation from information timing, we examine stock returns surrounding the departure of retiring CEOs, whose option holdings typically expire shortly after their departure and whose chances to manipulate option awards and exercises are minimized. Consistent with manipulated performance, we find significant abnormal stock returns in the months surrounding CEO departure for those with strong option incentives, which are reversed shortly after CEO departure.

Leverage, executive incentives and corporate governance

AbstractThis paper analyses the effect of executive incentives and internal governance on capital structure. Using a large sample of non‐financial US‐listed firms over the period 1999–2005, it is found that managers have different attitudes towards leverage when offered different incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchment–alignment effects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchment–alignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchment–alignment effects prevail under weak governance firms, whereas the alignment–entrenchment effects prevail under strong governance firms. The results also suggest that managers’ target leverage ratio is less than the one predicted by theory or preferred by firm shareholders.

Post-acquisition structuring of CEO pay packages: Incentives and punishments

Posited on the asymmetric features of equity ownership and stock option pay, this article examines the extent to which acquisition activities affect boards of directors’ decisions to restructure the incentive design of executive compensation packages in the post-acquisition period. For a recent dataset of 148 deals between 1996 and 2009, the article finds that acquirers’ overpayment for target firms and equity financing are likely to require scapegoating, particularly under conditions of intervening poor performance and stronger board vigilance, inducing directors to respond to CEOs’ overly risky and suboptimal selection of acquisition terms by enlarging the proportion of equity ownership disincentives at the expense of stock option incentives in executive pay contracts. By linking the incidence of large acquisition deals to an altered agency problem, the article proposes an alternative way to gauge how corporate boards enact their monitoring responsibilities based on CEOs’ recent past strategic choices.

A Test of the Incremental Power of CEO Productivity in Optimum Incentive Modelling

Employing a unique dataset with varying grant sizes and exercise prices, we test the competing optimal option incentive models of Hall and Murphy (2000, 2002) (HM) and Baker and Hall (2004) (BH) which differ with respect to the impact of CEO productivity on incentive determination and also the treatment of risk aversion and firm risk. Direct testing of the BH model proves more satisfactory than direct testing of the HM model, but given this outcome, it is surprising that the HM model explains a higher proportion of grant abnormal returns than does the BH model. We attribute this outcome to PPS and not the exercise price. Since exercise prices have been shown unrelated to agency problems, we conclude that caution needs to be exercised when prescribing exercise prices to create the optimal incentive, especially for highly risk-averse CEOs and those who are also poorly diversified.

Decision Engineering Analysis of Fraud Information Disclosure after China's Share-Splitting Reform

This paper outlines a dynamic game model to analyze the fraud information disclosure by listed companies in China since the share-splitting reform in 2005. By analyzing the conditions of coalition-proof Nash equilibrium between large shareholders and the manager, exogenous variables’ effects on the equilibrium as well as the first-order condition of the maximum utility of the supervisory department, it is concluded that efficient capital markets require a high supervising probability and intensity of penalty to the “insider” and shortened the intervals between supervising conducts as well. Moreover, there exists a unique optimum incentive stock option ratio over which fraud information disclosure becomes more rampant. This results in a higher intensity of penalty to the manager given more stock option incentive and, in contrast, a higher intensity of penalty to large shareholders of a well managed and efficiently capital-structured company once fraud information disclosure is detected. The model's conclusions are consistent with the facts of listed companies in China. Finally, the model makes sharp suggestions for the mechanism design of stock option incentive as well as suggestions for the supervisory department to achieve efficiency of capital markets in China.