CBR Briefing #7

How stock-options awards prompt executives to take on more debt and risk
The grants cause greater risk-taking, but not to the extent that one popular narrative suggests

An area chart plotting executives with stock-option plans, with percentages on the y-axis and the years of 1984 to 2010 on the x-axis. One band tracks executives with fixed-number plans which starts and holds at around fifteen percent before dropping to nine in 2010. A second band tracks those with fixed-value plans, with brings the total to about forty percent through most of the Eighties and Nineties, after which the total rises as high as forty-nine percent in 2005 before dropping to about twenty-six in 2010.

A 10% increase in the value of new options granted leads to a 2%–6% increase in the annualized volatility of daily stock returns.

  • Stock-options awards have been blamed for inducing executives to take excessive risks, but Chicago Booth’s Kelly Shue, in a research paper with Richard Townsend of Dartmouth College, argues that options grants only have moderate effects on risk-taking and may be an effective way to encourage risk-averse executives to take bigger gambles and to gain tax benefits from increased debt.
  • The authors compared companies that base options grants on the number of options, whose value changes with stock-price movements, with those that base them on the total value of the options, where value is fixed over a two- to three-year window (see chart).
  • A 10% increase in the value of new options granted leads to a 2%–6% increase in the annualized volatility of daily stock returns—the researchers’ measure of risk—in the year following the grant date.
  • A 10% increase in the value of new options awards also leads to lower dividend growth.
  • The effect of options awards on risk-taking is greater in the financial and technology sectors. This may be because executives have more ability to take on risk by using derivatives and pursuing products that are riskier to develop.

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