Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 104, Issue 1, Pages 70-88Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/j.jfineco.2011.11.005
Keywords
Executive compensation; Equity incentives; Risk-taking incentives; Systematic and idiosyncratic risk; Hedging
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The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative. (C) 2011 Elsevier B.V. All rights reserved.
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