AAA Spark Meeting of Regions

Option-Based Pay Incentives, Prior Losses, and Firm Performance

• In Event: Executive Compensation

Abstract

I investigate the consequences of CEO option-based pay incentives on risk-taking and future stock returns, conditional on past stock performance. The primary option-based pay incentive I focus on is vega, the sensitivity of CEO wealth to stock return volatility. Prior research documents a positive relation between vega and risk-taking. However, significant heterogeneity exists in executives’ risk preferences and hence, the efficacy of stock options to encourage risk-taking. I provide evidence that for firms with poor recent performance, high vega generates incentives for executives to take risk-reducing actions adverse to shareholders. In the period 1993-2018, for firms with poor prior 24-month stock performance (low performers), higher vega is associated with decreased R&D but increased capital expenditures and acquisition-related spending. Thus, high vega leads low performers to substitute intangible internal investment for tangible external investment, consistent with risk-averse managers engaging in conglomerate mergers to reduce risk of the combined entity (Amihud and Lev, 1981). These effects directly translate into future stock performance. Among the low performers, stock returns of high vega firms trail those of low vega firms by 0.68% per month over the subsequent year. Overall, my findings highlight the differential efficacy of vega on CEO risk-taking across firms with disparate performance histories. These results are consistent with the theory of Barberis, Huang, and Santos (2001), which suggests prior losses will heighten the fear of future losses and in turn, increase the aversion to risky choices.

Author

• Stephanie Dong, New York University