Academic journal article Academy of Accounting and Financial Studies Journal

The Effect of Executive Option Repricing on Managerial Risk-Taking

Academic journal article Academy of Accounting and Financial Studies Journal

The Effect of Executive Option Repricing on Managerial Risk-Taking

Article excerpt


In this paper we address the question, does reducing the risk on the manager, by repricing her out-of-the-money stock options, reduce firm risk We test this conjecture by studying changes in capital expenditure and R&D intensities, variances of stock returns and accounting returns, and implied variances in the traded call options around repricing of stock options. We find evidence indicating that capital expenditure intensity and variances of stock returns and accounting returns significantly decrease subsequent to repricing of stock options. This result is consistent with our hypothesis that repricing stock options encourages managers to take actions to reduce firm risk.

(ProQuest: ... denotes formulae omitted.)


Managerial stock options have played a critical role as an important component of executive compensation (Hall, 1998). Firms grant stock options to garner at least two important benefits. One is to increase the sensitivity of the manager's wealth to stock price by improving their incentives for future firm performance, and the second is to increase the sensitivity of manager's wealth to risk by decreasing managerial risk aversion (Guay, 1999).1 However, prior literature has shown that if the firm's stock price drops below the option's exercise price, 1) the incentive effect to increase stock price is severely reduced, because pay-for-performance sensitivity decreases (Murphy, 1999); and 2) the incentive to take risks (or the sensitivity of managers wealth to volatility) increases beyond what is optimal (Coles, et al., 2005; Rogers, 2004; Ju, Leland, and Senbet, 2003; Carpenter, 2000; Gilson and Vetsuypens, 1993). As Coles et al. (2005) and Kalpathy (2009) point out, it is possible to mitigate the reduction in the incentive to increase stock price, by issuing additional options. However, issuing additional options makes the second benefit worse by excessively increasing the manager's incentive to take risks, which may be detrimental to the firm. One alternative to this dilemma is to reprice the stock options. Repricing the underwater stock options has the potential to both restore the incentives to raise stock price and to reduce the incentive to take risk to more optimal levels, in essence to rebalance managerial equity incentives.2

Stock option repricing is the practice of resetting the exercise price of the underwater options to the new and lower market price by an amendment or by canceling underwater options and reissuing options with a lower exercise price (Saly, 1994). This repricing practice has been very controversial. The academic literature and public media have suggested both positive and negative aspects of this repricing practice. Supporters of repricing argue that it is necessary in order to restore incentives lost when the options are out-of-the-money and to retain highly talented managers especially in a competitive labor market. However, opponents argue that managers should suffer the consequences of their decisions and actions like other investors and not be shielded from the loss of value of the options. Institutional investor groups have also argued that repricing removes any downside risk on the manager reducing the benefits of option incentives (Moore, 1999; Reingold, 1999).

Prior papers have investigated several aspects of repricing: 1) the characteristics of firms that reprice, the optimality of repricing, and the timing of repricing3, and 2) the justification for repricing including the ability of the firm to retain executives and improvements in future performance4. The repricing controversy and literature however, seldom if ever, discuss the merit of repricing relative to reduction in managerial risk, which is the focus of this paper. Theory papers, like Carpenter (2000), show that deep underwater options result in excessive risk being placed on the manager and hence repricing may be one alternative to reduce this managerial risk. …

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