“The argument for paying a CEO with stock options is that it gives the executive an incentive to increase value for shareholders,” according to Capital ideas.
“If the CEO drives up the underlying stock price, the options award will be worth more. The problem is that a CEO may take excessive risks to drive up the share price. While that might increase the CEO’s compensation, he or she won’t necessarily share other shareholders’ pain if the stock loses value. Options exhibit “convexity,” which means options granted to CEOs have a potentially unlimited upside, while the downside is limited to zero if the stock doesn’t rise to the predetermined price.”
A new working paper from Kelly Shue and Richard R. Townsend, “Swinging for the Fences: Executive Reactions to Quasi-Random Options Grants,” finds a positive relationship between stock options and risk-taking, but “the magnitudes vary from large to near-zero.”
They fault prior research linking options to risk-taking because it “failed to control for other factors, such as changes in the business environment, which means any relationship identified might not be causal.”
Overall, the authors suggest that “executives take a moderate amount of risk when compensated with options—which Shue and Townsend point out may be an effective way to encourage risk-averse executives to take bigger gambles and to gain tax benefits from increased debt.”