(PhysOrg.com) -- A new study by a finance professor at Washington University in St. Louis finds that the amount of stock options in a CEOs compensation package can result in an increase in risk-taking by company leaders.
Such a finding seems obvious at first blush, but uncovering clean empirical evidence always has been illusive, says Todd A. Milbourn, PhD, the Hubert C. and Dorothy R. Moog Professor of Finance at Olin Business School.
Our findings suggest that the structure of a managers compensation significantly affects how managers will guide their firms in reaction to large, adverse shocks, such as disruptive product innovations, relaxation of international trade barriers or changes to government regulation, Milbourn says.
Milbourns research is presented in CEO Compensation and Corporate Risk-Taking: Evidence from a Natural Experiment, written with Todd Gromley, PhD, assistant professor of finance at the University of Pennsylvanias Wharton Business School, and David Matsa, PhD, assistant professor of finance at Northwestern Universitys Kellogg School of Management.
Milbourn and his co-authors find that CEOs with compensation that is more like? based on straight-equity holdings (which occurs when the executive holds lots large amounts of restricted stock and/or deep-in-the-money options) tend to reduce cash flow within the company after volatility to these risks increases.
On the other hand, firms whose CEOs have compensation more contingent upon upside performance tend to roll the dice by not reducing cash flow volatility to insulate the firm from risk.
To answer the question of how options impact risk taking, the researchers decided to study companies with set compensation arrangements in place that had an unexpected increase in their risk profile.
In particular, they analyzed firms responses to increased risk created when a chemical that workers had already been exposed to is later determined by the federal government to be a possible carcinogen.
When this kind of thing happens, a companys legal fees, damage payments and insurance premiums can skyrocket, Milbourn says. It can also lead to future workplace safety regulations than can be very costly to implement. Spending all of that money can increase the likelihood of poor company performance, which lets us clearly identify and study an increase in a firms business risk.
To find the right companies, the researchers looked at a federal study called the National Occupational Exposure Survey, which documents workers exposure to more than 13,000 chemical, physical or biological substances.
The authors then identified companies in industries with observed exposures to newly listed carcinogens for which they could find detailed CEO compensation figures. In the end, they concentrated on 69 firms.
The group studied the impact of a newly labeled carcinogen in a number of ways. They looked at companies in industries where employees had been exposed to a chemical recently tagged a potential carcinogen versus firms in industries that did not have exposure. The question was whether firms with a potential exposure would try to cut their risk by stabilizing their cash flow, thereby reducing firm risk.
What they found is that the firms in industries that did not use the chemical tended not to make those cash flow stabilizing moves. A further analysis of mergers and acquisitions activity during the period revealed that the key mechanism for slashing cash flow volatility for those affected firms was diversifying into new businesses.
The researchers found that boards of directors interested in discouraging excessive risk taking could use restricted stock options as part of CEO pay packages. Granting stock options encourage the greatest risk taking, even while they are relatively inexpensive when issued.
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