Do Executive Stock Options Encourage Risk Taking?
One of the oft-cited justifications for the use of stock options as part of a compensation package is the notion that stock options make the executives more wiling to take risks, more entrepreneurial and less bureaucratic.
Though the matter is a continuing bone of contention among economists, a strong case may be made that executive stock options (ESOs) only encourage risk taking for certain firms, those with low stock-price volatility, while discouraging it for other firms, though with high volatility.
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Stock Options
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A stock option is a contract granting the holder the right to buy (or sell) a certain stock at a specific price on a specific future date. The type of stock option given as executive compensation is a "call" option -- a right to buy. If on the specified date the market price of the stock is less than the price contracted for, then of course the option will expire unused. After all, the right to buy a certain stock for $50 is of no value if the stock is available in the market for $40.
ESOs As Compensation
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An advocate of ESOs will say that an executive who owns such options, with a strike price of $50, will have an obvious incentive to keep the price of the underlying stock above $50, and that this aligns his incentives with the stockholders. A risk-averse manager who is paid only his salary may be more content to see the stock price fall to $40.
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Theories
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Critics of ESO such as Roger Lowenstein -- a financial journalist who wrote the Wall Street Journal's influential "Heard of the Street" column from 1989 to 1991, have contended that executives are emboldened by stock options to pump up the price of the stock above what the underlying value of the company could long sustain. "A poker player will bet aggressively when he is playing with the 'house money,'" Lowenstein wrote in "Origins of the Crash" (2004). A chief executive officer (CEO) who has received options from his company has "simply won the options lottery" and will be accordingly aggressive, on this analogy.
Human and Capital Resources
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One way of looking at the ESO issue is to see a CEO's own time and energy as part of his portfolio. He has these human resources bound up in the success or failure of one firm. He can not easily diversify. Indeed, the idea of portfolio diversification would suggest that he should invest his money in firms other than his own, ideally in other industries and in other countries as well, using his capital resources to balance his human resources.
Paying a CEO in ESO tied to the underlying stock of the company he leads limits his ability to balance his portfolio in this way, and may help make him risk-averse. While he won't want his company's stock price to decline to $40 if his options have a strike price of $50, it is also the case that he may be satisfied with a play-it-safe stance likely to keep the stock price at $60, and reluctant to take risks that could (if successful) lead to a stock price of $100.
Expert Insight
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"Managers in more volatile firms are less likely to take risks, even if they are heavily loaded with options, because the potential cost of increasing risk may exceed the benefit of increasing option value," wrote Wenli Huang, assistant professor of accounting at Boston University School of Management. Huang undertook an empirical study of this question for her doctoral dissertation, submitted to the University of California, Berkeley, in 2005.
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