Risk-Taking Incentives of Executive Stock Options and the Asset Substitution Problem

21 Pages Posted: 2 Feb 2005

See all articles by Gerald T. Garvey

Gerald T. Garvey

Blackrock

Amin Mawani

York University - Department of Accounting

Abstract

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.

JEL Classification: J33, G32, D82, G34

Suggested Citation

Garvey, Gerald T. and Mawani, Amin, Risk-Taking Incentives of Executive Stock Options and the Asset Substitution Problem. Available at SSRN: https://ssrn.com/abstract=656105

Gerald T. Garvey (Contact Author)

Blackrock ( email )

Level 37, Chifley Tower
2 Chfiley Square
Sydney, NSW 2000
Australia
+61 2 9272 2388 (Phone)

Amin Mawani

York University - Department of Accounting ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

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