This article was downloaded by: [128.255.246.218] On: 08 September 2017, At: 11:21 Publisher: Institute for Operations Research and the Management Sciences (INFORMS) INFORMS is located in Maryland, USA Management Science Publication details, including instructions for authors and subscription information: http://pubsonline.informs.org Do Stock Options Overcome Managerial Risk Aversion? Evidence from Exercises of Executive Stock Options Randall A. Heron, Erik Lie To cite this article: Randall A. Heron, Erik Lie (2017) Do Stock Options Overcome Managerial Risk Aversion? Evidence from Exercises of Executive Stock Options. Management Science 63(9):3057-3071. https://doi.org/10.1287/mnsc.2016.2485 Full terms and conditions of use: http://pubsonline.informs.org/page/terms-and-conditions This article may be used only for the purposes of research, teaching, and/or private study. 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For more information on INFORMS, its publications, membership, or meetings visit http://www.informs.org MANAGEMENT SCIENCE Vol. 63, No. 9, September 2017, pp. 3057–3071 http://pubsonline.informs.org/journal/mnsc/ ISSN 0025-1909 (print), ISSN 1526-5501 (online) Do Stock Options Overcome Managerial Risk Aversion? Evidence from Exercises of Executive Stock Options Randall A. Heron,a Erik Lieb a Kelley School of Business, Indiana University, Indianapolis, Indiana 46202; b Henry B. Tippie College of Business, University of Iowa, Iowa City, Iowa 52242 Contact: [email protected] (RAH); [email protected] (EL) Received: June 24, 2014 Abstract. We report that the probability that executives exercise options early decreases Revised: May 19, 2015; December 17, 2015; with the volatility of the underlying stock return. We interpret this to mean that executives’ February 2, 2016 subjective option value increases with volatility and that option grants increase executives’ Accepted: February 15, 2016 risk appetite. Further decomposition reveals that the results are most pronounced for Published Online in Articles in Advance: idiosyncratic volatility, consistent with our conjecture that executives believe they can July 14, 2016 better predict or influence the resolution of idiosyncratic uncertainty than systematic https://doi.org/10.1287/mnsc.2016.2485 uncertainty and, thus, favor the former. Copyright: © 2016 INFORMS History: Accepted by Wei Jiang, finance. Keywords: finance • corporate finance • management • executive compensation 1. Introduction Bettis et al. (2005) explore ESO values and incentives Jensen and Meckling (1976) describe how the interests further, with a particular emphasis on the role of exer- of executives and shareholders diverge when executives cises. In their utility-based valuation model (which is maximize their own utility rather than shareholders’ an extension of Carpenter 1998), executives exercise if wealth. Without proper incentives, executives generally the stock price reaches a “threshold price,” such that prefer to consume perquisites and undertake less risk the utility from locking in the gain exceeds the util- than what optimizes firm value. Jensen and Meckling ity from holding the option. Bettis et al. (2005) esti- suggest that one solution to reduce the divergence of mate that an increase in the stock price volatility from interests is “to establish incentive compensation sys- the base-case parameterization of 39% to 58% is asso- tems for the manager or to give him stock options which ciated with a higher stock price upon exercise and in effect give him a claim on the upper tail of the out- a higher subjective valuation. Thus, it appears that come distribution” (p. 353). Other studies, including higher volatility raises the threshold price as executives Smith and Stulz (1985) and Guay (1999), support the place greater value on holding the options. They fur- ther calibrate their model to a sample of option grants view that option-based compensation mitigates man- in the Execucomp database between 1992 and 2002 and agerial risk aversion and induces greater risk-taking report that the average subjective convexity is positive. behavior. The underpinning for these studies is that Overall, the theoretical studies provide equivocal the objective option value, e.g., the Black–Scholes value, predictions on the effect of ESOs on executives’ risk is a convex function of the stock value and therefore appetite. Past empirical studies provide evidence using increases with stock price volatility. two different testing frameworks, and thus we place However, two factors complicate the application of the studies in two different camps. The first camp, objective value functions for executive stock options to which our study belongs, examines the effect of (ESOs). First, ESOs are not easily transferable; i.e., stock return volatility on the timing of ESO exercises. executives cannot sell ESOs nor fully hedge their If risk enhances executives’ subjective ESO valuation exposure without violating company policies. Second, (meaning that ESOs increase risk appetite), higher risk executives are inherently undiversified, with dispro- should discourage executives from early exercise. Con- portionate financial and human capital invested in the Downloaded from informs.org by [128.255.246.218] on 08 September 2017, at 11:21 . For personal use only, all rights reserved. sistent with this view, Carpenter et al. (2013) report company. On this backdrop, Lambert et al. (1991), that employees retain their options when volatility Carpenter (2000), Hall and Murphy (2002), and Ross is high, with the caveat that the employees in their (2004) show that risk-averse executives place a lower sample include nonexecutives, whereas Izhakian and value on their ESOs than do diversified investors and Yermack (2016) find that executives retain options in that the concavity of executives’ utility functions could the presence of high volatility. In addition, Huddart eclipse the convexity of the option payoffs, in which and Lang (1996) document evidence, albeit statistically case ESOs would encourage less risk-taking behavior. weak, that the top five percent level employees retain 3057 Heron and Lie: Do Stock Options Overcome Managerial Risk Aversion? 3058 Management Science, 2017, vol. 63, no. 9, pp. 3057–3071, © 2016 INFORMS options when volatility is high. Conversely, Hemmer the original grants. The advantage of this approach et al. (1996), Bettis et al. (2005), and Klein and Maug is that we get valuable information about the options (2011) find that executives are more likely to exercise from the original grant filings (including the total num- their options early in the presence of high volatility.1 ber of options granted, years to maturity, and vesting However, unlike the former three studies, these lat- dates) and can track what happens to the options over ter three studies compare early exercises to late exer- time. Also, our approach allows us to compare the deci- cises, which makes their results susceptible to secular sion to exercise options to contemporaneous decisions not trends. As an example, stock prices are often described to exercise options rather than to later decisions to exer- as a stochastic process with a positive drift. It follows cise options. Thus, we mitigate the concern caused by that, all else equal, later exercises will be associated systematic time-trends in the covariates. with higher moneyness than early exercises, yielding We find that high volatility discourages executives the potentially misleading inference that executives from exercising their options. We also show that the are more likely to exercise options early when they difference in results in our study versus those in earlier are less in-the-money. Another possibility is that stock studies is primarily attributable to our methodology of price volatility naturally declines as firms mature, such comparing early exercises to nonexercises rather than that early exercises are associated with higher volatil- to late exercises. We interpret our results as evidence ity. Indeed, in our sample, both total and idiosyncratic that executives place a higher value on ESOs when volatility tends to decline from the year of the option volatility is high. Thus, to the extent that the execu- grants through the maturity year. tives are inherently risk averse, the convexity of the The second empirical camp leaps the question of option payoff overcomes the concavity of their utility whether ESOs increase risk appetite to the ques- functions. tion of whether ESOs lead to greater risk taking. We further examine the differential effects of Numerous studies report that ESOs (often measured idiosyncratic volatility and systematic volatility. by their objective convexity) lead to riskier corpo- Armstrong and Vashishtha (2012) argue