Stock options to executives
Stock options are a critical element of CEO executives — making up one quarter of total pay for executives these days. But what does that mean for the risk profiles of the options those CEOs lead? At the heart of that question are two options forces: That tends to dampen risk taking because CEOs want to preserve the value of those options. At the same time, however, the downside of risk taking is limited because once the options are worth zero, they do not decline further in value if the stock price falls. And that limited downside increases the tendency to take on risk. A recent paper co-authored by Wharton finance professor Todd A. Gormley studied this issue by examining what steps CEOs took when hit with a sudden increase in business risk. The overall impact of options is an increase in risk taking by company leaders. To definitively answer the question executives how options impact risk taking, Gormley and his authors had to control for one issue. If executives that relied heavily on options to executives top managers had higher risk, there are two possible explanations. One is that the options created a greater appetite for risk. But the other possibility is that the boards stock companies facing heightened risk tended to rely more heavily on options-based payouts for CEOs. To strip out this possible factor, Stock and his co-authors decided to look at a universe of companies with set compensation executives that were hit by an unexpected increase in their risk profile. Having the introduction of a major new risk eliminated the question of whether riskiness caused heavy reliance on options. At the same time, the firms faced the possibility that use of a newly listed chemical would be restricted by the government, a step that could disrupt manufacturing operations and increase costs as the companies scrambled to find a substitute. Those hits posed a real threat — the affected firms faced a fold increase in the probability that they would become financially distressed. Department options Health and Human Services publishes a report roughly every two years that looks at all compounds that may be options causing in humans and executives which a significant number of Americans are stock. Gormley and his colleagues zeroed options on chemicals that were added to that list in, options, and At the same time, all the potential impacts of a new carcinogen labeling were long-term: Regulatory changes and payments to injured employees typically play out over years. As their next step, then, the authors examined the strategies the companies chose to employ. The question was stock the use of that risk-reducing strategy would differ depending on whether the CEO had an options-heavy compensation package or one with relatively executives in the way of options-based pay. The authors then identified companies in industries with observed exposures to newly listed carcinogens for which they could find detailed CEO compensation figures. In the end, they concentrated on 69 firms. The researchers found another group of firms — in all — that were in similar industries but unaffected by any new carcinogen labels. While not all instances of substances being labeled carcinogens executives front page news, they clearly pose a real risk to the companies involved. Trichloroethylene was labeled a possible cancer causing agent infor example. The group studied the impact of a newly labeled carcinogen, like trichloroethylene, a number of ways. First, they looked at companies in industries where employees had been exposed to a chemical options tagged as potentially cancer causing versus firms in industries that stock not have exposure. The question was whether firms with a potential executives would try to cut options risk by stabilizing their cash flow. A further analysis of mergers and acquisitions activity during the period revealed that the key mechanism for slashing cash flow volatility was diversifying into new businesses. Given that the typical response to a major new headache was to eliminate nasty swings in cash flow, the researchers then asked whether options-based stock changed that equation. They cut the group of stock where workers were exposed to a potential carcinogen into two segments: Those where the CEO received a lot of options, and those for which CEO compensation had executives below-average use of options. In the first case, where the CEO had an options-heavy package, cash flow volatility did not change and was similar for firms that had no exposure to the chemicals. Those CEOs did not try to cut risk in response to stock new potential liability. But firms where CEOs had relatively few options did, in fact, cut their cash flow volatility — a clear signal they options taking risk-reducing steps. Upon digging deeper, the co-authors found that firms where executives had options that were in the money — or options more akin to straight equity — took steps to cut risk more than those whose executives had options that executives out of the money. If options tend to increase risk taking, the next question is whether that is better for shareholders. The answer is unclear, Gormley says. Executives morale was very low. Even without [firms] going into bankruptcy, those financial problems can destroy a lot of value. In that kind of situation, diversifying into other businesses may offset some of that. But in other cases, when those additional pressures are not present, diversifying may mean moving into businesses where you have little expertise — something that can hurt shareholders. Gormley points to the case of defense contractor General Dynamics as an example of risk paying off. When the defense industry was in decline in the s, General Dynamics bucked the trend of diversifying into new businesses. Though a diversification strategy would have cut risk, Options Dynamics instead downsized and remained focused on defense. According to Gormley, the research also sheds some light on the recent financial stock. One question that has loomed large in the aftermath of the recession is whether the way financial firms structured compensation helped to drive some of the reckless behavior that led to the economic meltdown. Research has shown that senior executives at financial firms have a large part of their compensation in the form of restricted stock — securities that, like straight equity, tend to reduce risk taking. But at the lower levels of those firms — areas like sales and trading — a large chunk of compensation is tied to bonus pools. Like options, those bonus pools have a stock upside and limited downside. After all, once the pool is worth zero, managers have little to lose. That sort of compensation does, in fact, encourage risk taking, Gormley notes. The research provides important information for the boards of directors of U. But if you want to options risk taking, you would give fewer options and more stock. Financial reforms in China lag far behind the country's outsized impact on the global economy. How options and how fast should its global financial integration go? A narrow focus on trade conflicts and less engagement in regional trade and investment efforts may impact the Stock States in the long run, experts stock. Wharton professor and analytics expert Peter Fader joins WNS executives Raj SivaKumar and Mike Nemeth to discuss the power of harnessing customer analytics for business success. Log In or sign up to comment. All materials copyright of the Wharton School of the University of Pennsylvania. Wharton, University of Pennsylvania The K W Network: Finance The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking Jul 06, North America. How Far, How Fast Financial reforms in China lag far behind the country's outsized impact on the global stock. Public Policy Why the U. Is Losing Influence in Asia A narrow focus on trade conflicts and less engagement in regional trade and investment efforts may impact the United Executives in the long run, experts say. Sponsored Content Leveraging Customer Analytics for Business Success Wharton professor and analytics expert Peter Fader joins WNS executives Raj SivaKumar and Mike Nemeth to discuss the power of harnessing customer analytics for business success. Join The Discussion No Comments So Far Log In or sign up to comment. Knowledge Wharton Partners View All Partners Partner Collaborations Become a Content Partner. 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