One change to a CEO's pay package can make them take more chances

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An increase in the weight of options in the CEO's compensation package is associated with an increase in stock price volatility, largely because stock options and risk taking dubai greater firm leverage. Increasing corporate leverage appears to be the key channel through stock options and risk taking dubai CEOs raise volatility. Increasing the stock options and risk taking dubai of a CEO's pay that takes the form of option grants might raise or lower risk-taking.

Because the value of an option on a given company's stock rises with the volatility of that company's stock price, and because the value of an option cannot go below zero, stock options and risk taking dubai CEOs have an incentive to take more corporate risk and thereby increase price volatility.

However, there is a countervailing effect: As the share of the CEO's portfolio that is exposed to the company's stock price rises, as it does when option grants rise, a risk-averse CEO might try to stock options and risk taking dubai overall portfolio volatility by lowering the volatility of the company's share price. This would entail a shift toward more conservative, less risky business strategies. They observe that many firms have multi-year option programs, which means award grants are not likely to be driven by changing investment opportunities at the firms in the study.

There are two broad types of option-linked compensation schemes: Under a fixed-value plan, executives are awarded stock options with a given value during each year of the multiyear program. If the company's stock price rises between the first and second year of the grant program, thereby raising the value of each option granted, the number of options awarded in the second year would be smaller than the number in the first.

In contrast, fixed-number plans award executives a set number of options in each year of the compensation program. The value of the annual awards under such a program can vary substantially as a result of movements in the company stock price and other factors. The researchers exploit the fact that in a rising stock market, as stock prices trend higher, CEOs on fixed-number plans will receive a rising fraction of their compensation in the form of options, while the value of option awards to CEOs on fixed-value plans will not rise commensurately.

The researchers conclude that, on average, "risk-taking increases when options as a fraction of total pay increase. The effects are particularly pronounced at financial and high-tech companies.

The researchers explore the sources of increased stock price volatility and conclude that it is primarily due to an increase in corporate leverage — a strategy that is broadly available to CEOs and their firms. The views expressed in this article are those of the author alone and not the World Economic Forum. We are using cookies to give you the best experience on our site.

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