Why Stock Options Lead to More Risk Taking

We have recently discussed some interesting research on the use of incentives to drive R&D performance.  We learned that incentive bonus plans tend to make executives modify goals to ensure incentives are obtained. We also learned that stock options are not actually seen as performance drivers but gifts from the company.  Financial incentives themselves have been seen as not very effective towards driving true performance.  Now there is one more piece of the puzzle from Knowledge@Wharton (The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking):

The research is laid out in a new paper, ‘CEO Compensation and Corporate Risk Taking: Evidence from a Natural Experiment,’ by Gormley, David Matsa, a professor at Northwestern University’s Kellogg School of Management, and Todd Milbourn, a professor at Olin Business School at Washington University in St. Louis. ‘Options do have an effect on risk taking,’ Gormley says. ‘That is something that should be factored into compensation structure by boards of directors.’

As we have discussed earlier, stock options are increasingly used as part of the compensation package:

Stock options are a critical element of CEO compensation — making up one quarter of total pay for executives these days. But what does that mean for the risk profiles of the companies those CEOs lead?

The problem is that stock options only work in one way – towards the upside.  If the stock price falls below the option value, they are worth zero (not negative).

At the heart of that question are two opposing forces: There is a risk-tempering aspect to options, because when those options are “in the money” — meaning the exercise price is less than the current market price — the value of those options moves in line with the stock price. That tends to dampen risk taking because CEOs want to preserve the value of those options.
At the same time, however, the downside of risk taking is limited because once the options are worth zero, they do not decline further in value if the stock price falls. And that limited downside increases the tendency to take on risk.

In summary use straight equity instead of options to moderate risk taking :

Research has shown that senior executives at financial firms have a large part of their compensation in the form of restricted stock — securities that, like straight equity, tend to reduce risk taking. But at the lower levels of those firms — areas like sales and trading — a large chunk of compensation is tied to bonus pools. Like options, those bonus pools have a large upside and limited downside. After all, once the pool is worth zero, managers have little to lose. That sort of compensation does, in fact, encourage risk taking, Gormley notes.

I am getting more and more convinced that the best approach is to measure risk taking and reward it using concrete metrics instead of using indirect tools such as options…