An empirical assessment of the risk incentive provided by executive stock option portfolios

This dissertation investigates the empirical relation between the risk-taking incentive provided by option compensation and measures of firm risk for a pooled sample of firms taken from Compustat's ExecuComp database for the 1992–1998 period. Specifically, it examines how the extent to which executive stock options are in or out of the money affects the relation between the risk-taking incentive provided by executive stock option portfolios and a firm's equity risk. It also explores the relations between the risk-taking incentive resulting from stock option portfolios and specific managerial financing, operating and investment decisions. It shows that the relation between the risk-taking incentive and equity risk is greater than predicted by using the Black-Scholes option pricing model when the executive's option portfolio has a high probability of expiring out of the money. It also shows that the risk-taking incentive provided by executive option portfolios that are deep in the money is negatively related to the firm's equity risk. The dissertation shows that the pattern of the relation between the risk incentive provided by option compensation and a firm's asset risk is similar to the pattern of the relation between the risk incentive and equity risk. The dissertation does not find a relation between the risk incentive provided by option compensation and a firm's leverage ratio or research and development spending. The dissertation does not find that a change in the risk incentive provided by option compensation is related to a subsequent change in equity risk, asset risk, the leverage ratio or research and development spending in the following year.