An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Wenli Huang
Boston University School of Management

Abstract: It is commonly believed that the convexity property of stock-option compensation contracts can induce managers to take riskier actions. However, this kind of reasoning ignores the effects of managerial risk-aversion. A risk-averse manager cannot fully diversify firm-specific risk, and hence will discount the value of an increase in stock volatility. Using ExecuComp data from 1992 to 1998, I provide direct evidence that executive stock options (ESOs) do not necessarily induce managerial risk-taking. In particular, I find that for firms with low (high) earnings volatility and stock-return volatility, CEO option holdings are positively (negatively) correlated with ex-post risk-taking outcomes proxied by future earnings and stock-return volatility. The results indicate that ESOs encourage (discourage) risk-taking for firms with low (high) volatility. Thus, I conclude that using ESOs as a device to mitigate the underinvestment problem is effective only for some firms.

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