Academic journal article Financial Management

The Effect of Executive Stock Options on Corporate Innovative Activities

Academic journal article Financial Management

The Effect of Executive Stock Options on Corporate Innovative Activities

Article excerpt

This study investigates whether the implicit optionality of executive stock options (ESOs) induce managers to undertake innovative activities associated with various types of risk. We find ESO risk incentive (vega) to be positively correlated with all types of corporate innovations. We also find greater ESO risk incentive effects for the product-related innovative activities that are associated more with systematic risk than idiosyncratic risk. Finally, we document the following pecking order for the ESO risk incentive effects: improved product, new product, alliance, and new research and development. Our results suggest that executives have more incentive to invest in projects with higher systematic risk.

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Prior research provides two opposite predictions regarding whether executive stock options (ESOs) can increase managerial risk-taking. The convexity payoff scheme of ESOs suggests that ESOs can increase managerial risk-taking (Haugen and Senbet, 1981; Smith and Stulz, 1985). The Rajgopal and Shevlin (2002) finding of a positive correlation between the risk incentive of ESOs and future oil exploration supports this prediction. Alternatively, the risk aversion of executives may constrain the incentive effect of ESOs on managerial risk-taking (Ju, Leland, and Senbet, 2002; Larraza-Kintana et al., 2007). Moreover, Lambert, Larcker, and Verrecchia (1991), Carpenter (2000), and Ross (2004) argue that risk-averse executives may not always increase their risk appetite with the risk incentive of ESOs, unless the incentive is high enough to change their utility of wealth. Recently, Chen and Lee (2010) find that although ESOs may induce managerial risk-taking, this risk-taking incentive is short-lived. Thus, they conclude that ESOs may not always function as long-term incentive compensation as expected.

Recent studies positing that the risk incentive effect of ESOs varies with the type of risk-taking may reconcile these seemingly conflicting arguments. For example, with limited capital resources, ESOs provide chief executive officers (CEOs) with an incentive to allocate resources to intangible investments such as research and development (R&D) versus tangible investments such as capital expenditures (Cole, Daniel, and Naveen, 2006). Alternatively, the vega effect of ESOs provides CEOs with an incentive to engage in corporate activities that are associated with different types of risk, systematic and idiosyncratic risks (Tian, 2004; Duan and Wei, 2005; Armstrong and Vashishtha, 2012). ESOs provide both the delta and vega incentives. The delta effect provides an incentive to increase stock price, while the vega effect provides an incentive to increase stock return volatility (i.e., risk). These studies identify that the vega effect (risk incentive effect) of ESOs increases firm risk primarily through the increase of systematic risk rather than through the increase of idiosyncratic risk. Therefore, ESOs may not necessarily provide executives with the incentive to invest in a project that has a positive net present value (NPV) and also high idiosyncratic risk. Given that the majority of CEOs in the US rank stimulating innovation as one of their top objectives for firm long-term growth and profitability (Rudis, 2004), this study extends the ESO literature by investigating whether ESOs provide managers with an incentive to undertake various innovative activities associated with different types of risk. (1)

We contribute to the literature in two ways: First, we identify the incentives (delta and vega) of ESOs and relate them to a wide spectrum of corporate innovative activities measured by new products, improved products, technological alliances, and new R&D activities. Additionally, while the literature has made distinctions between different types of investment activities and their effects on firm risk (Cole et ah, 2006), we extend this strand of literature and distinguish the relation between different innovative activities and systematic risk/idiosyncratic risk. …

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