Premium
Risk‐taking incentives of executive stock options and the asset substitution problem
Author(s) -
Garvey Gerald T.,
Mawani Amin
Publication year - 2005
Publication title -
accounting and finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.645
H-Index - 49
eISSN - 1467-629X
pISSN - 0810-5391
DOI - 10.1111/j.1467-629x.2004.00122.x
Subject(s) - executive compensation , leverage (statistics) , incentive , restricted stock , equity (law) , stock (firearms) , non qualified stock option , business , stock options , empirical evidence , economics , financial economics , finance , actuarial science , microeconomics , stock market , mechanical engineering , paleontology , philosophy , horse , epistemology , machine learning , computer science , political science , law , biology , engineering
Various theoretical models show that managerial compensation schemes can reduce the distortionary effects of financial leverage. There is mixed evidence as to whether highly levered firms offer less stock‐based compensation, a common prediction of such models. Both the theoretical and empirical research, however, have overlooked the leverage provided by executive stock options. In principle, adjusting the exercise prices of executive stock options can mitigate the risk incentive effects of financial leverage. We show that the near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage. In a large cross‐sectional sample of Canadian option‐granting firms, we find evidence that executives' incentives to take equity risk are negatively rather than positively related to the leverage of their employers.