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Liaisons and intrigues
“More risk!?” you might think. Do we really want CEOs of large
corporations to take more risk?! Is it not, given recent events in
the world of business, that we would like our top executives
to be a little less risk-taking for a change? Ah, that’s what you
might think now, but it is not what agency theory thinks, and it
is not what the incentive structure of most public corporations
nowadays is geared to do.
Because stock options do stimulate risk-seeking behavior, as
we know from scientic research. Options, as you might know,
represent a right to buy shares at a certain price at some xed
point in the future. If you are given the right to buy a share in
company X for $100 in January 2010 and by then the share price
of X is $120, you will make 20 bucks per share. However, if the
company’s share price by then has dropped to $90, your option
is worthless; we say it is “out of the money”: you’re not going
to exercise your right to buy at $100 when the market price is
merely $90.
In that situation, if the CEO of X has many stock options, it
stimulates him to be very risk-seeking. For example, if by August
2009 the share price is $90, he will be inclined to engage in risky
“win or lose” moves. If the risk pays off and the share price rises
well above $100, the stock options will become worth a lot of
money. However, if he loses, and the share price plummets even
further, say to $60, it doesn’t matter. The stock options to buy at
$100 were worthless anyway, whether the stock trades at $90 or
at $60.
But what sort of risk-taking does this really lead to? Because what
agency theory has not really acknowledged and explored is that
there are various types of risk. Some risks may be good; some are
not so good . . . Are we sure that stock options lead to sensible
risk-taking?
Stock options, risk, and manipulations
No, I am not so sure. Two strategy professors have actually
measured this: Gerry Sanders from Rice University and Don
Business Exposed112
Hambrick from Penn State University. They examined 950
American CEOs, their stock options and their risk-taking
behavior. They found that CEOs with many stock options made
much bigger bets: for instance, they would do more and larger
acquisitions, bigger capital investments, and higher R&D expend-
itures. That is, where CEOs with few stock options would prefer
to invest $50 million in a particular project, they would plunge
in $100 million.
However, in addition, they would bet (that rather substantial
amount of) money on things that had much higher variability.
That is, if there was a project that could make them win or lose
20 percent of the sum invested and another project that could
make them win or lose 50 percent, they would pick the latter; big
bets with lots of variance.
Yet, I guess those could still be regarded “good risks”. Gerry and
Don, however, also found something else: option-loaded CEOs
delivered signicantly more big losses than big gains! They
would more often lose than win the big bets. Surely that is not
something anyone would want.
And why is that? Well, through these stock options, you have
created individuals at the helm of your rm who only care about
the up-side, but can’t be bothered with the size of the down-side;
whether they lose $10 million or $100 million, their stock
options are worthless anyway.
And it gets worse. Professor Xiaomeng Zhang and colleagues,
from the American University in Washington, D.C., examined
the relationship between stock options and earnings manipu-
lations: plain illegal behavior. They investigated 365 earnings
manipulation cases and showed that CEOs with many “out
of the money” options were more likely to misrepresent their
company’s nancial results (and get caught doing it!).
And I guess that’s not something even the biggest risk-loving
shareholder would applaud. Hence, even if as a board member or
shareholder you’d want to stimulate your CEO to take more risks
– and I guess that is a big if – I am not so sure that stock options
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