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Risk‐taking incentives of executive stock options and the asset substitution problem

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  • Gerald T. Garvey
  • Amin Mawani

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.

Suggested Citation

  • Gerald T. Garvey & Amin Mawani, 2005. "Risk‐taking incentives of executive stock options and the asset substitution problem," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 45(1), pages 3-23, March.
  • Handle: RePEc:bla:acctfi:v:45:y:2005:i:1:p:3-23
    DOI: 10.1111/j.1467-629x.2004.00122.x
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    References listed on IDEAS

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    1. Brian J. Hall, 1998. "The Pay to Performance Incentives of Executive Stock Options," NBER Working Papers 6674, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Michael Puleo & Michael McDonald & Steven Kozlowski, 2021. "Share‐pledging and the cost of debt," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 61(1), pages 1047-1079, March.
    2. Balachandran, Balasingham & Faff, Robert, 2015. "Corporate governance, firm value and risk: Past, present, and future," Pacific-Basin Finance Journal, Elsevier, vol. 35(PA), pages 1-12.
    3. Hsiang-Lan Chen & Wen-Tsung Hsu & Yen-Sheng Huang, 2010. "Top management team characteristics, R&D investment and capital structure in the IT industry," Small Business Economics, Springer, vol. 35(3), pages 319-333, October.
    4. de La Bruslerie, Hubert, 2016. "Does debt curb controlling shareholders' private benefits? Modelling in a contingent claim framework," Economic Modelling, Elsevier, vol. 58(C), pages 263-282.

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