The effects of the CEO's stock option portfolio on stock return volatility and firm performance

I examine the incentive effects of CEO stock option portfolios on future stock-return volatility and future firm performance for a sample of CEOs taken from the ExecuComp database. Previous studies have generally treated executive stock options with the same calculated Black/Scholes value as providing the same incentives for managers to increase equity risk and improve firm performance. However, the incentive effects depend on the relation between option value and stock-return volatility (i.e., ESO volatility sensitivity) as well as the relation between option value and stock price (i.e., ESO stock price sensitivity). I predict there will be a positive relation between future stock-return volatility and ESO volatility sensitivity and the evidence is not consistent with this prediction. I predict a positive relation between future long-term firm performance (i.e., net income) and ESO stock price sensitivity and the evidence is consistent with this prediction. Further tests indicate it is the vesting restrictions of stock option compensation that drive the relation between long-term firm performance and ESO stock price sensitivity. Empirical tests are conducted using an approximation method developed by Core and Guay (1998). This method enables me to estimate ESO stock price sensitivity and ESO volatility sensitivity using the ExecuComp database. Previously, extensive hand collection of data was needed to compute these ESO sensitivity measures. I use these ESO sensitivity measures as estimates of the incentive effects of my sample of CEO stock option portfolios and test my predictions using a cross-sectional OLS regression.