Executive Stock Options and Leverage

Download or read book Executive Stock Options and Leverage written by Lee W. Sanning and published by . This book was released on 2003 with total page 41 pages. Available in PDF, EPUB and Kindle. Book excerpt: Executive stock options as a form of managerial compensation have come under intense scrutiny in recent months. Agency theory has held that options granted to executives should resolve some conflicts between managers and stockholders (Jensen and Meckling, 1976, and Haugen and Senbet, 1981). Yet recent events highlight the additional and perverse incentives that executive stock options can create. The role that executive options may have played in the collapse of firms like Enron is currently being debated in the popular press as well as by legislators and regulatory officials. Testifying before congress, Alan Greenspan recently said quot;there has been a severance, in my judgment, of the interests of the chief executive officer in many corporations from those of the shareholdersquot; (February 27, 2002). This severance can lead to risk taking by the corporate manager, beyond that preferred by the shareholders. One such type of risk taking is the increased use of financial leverage. Prior empirical research documents a positive contemporaneous relationships between executive options and leverage. These studies argue that executive options induce risk taking on the part of the manager and so interpret this finding as an indication that higher option grants cause higher leverage. I explicitly test for a causal relationship between executive options and leverage. I find that executive options cause financial risk taking when there is low institutional monitoring (ownership). However, for high institutional ownership, I find that this is not the case. Rather, following increases in firm risk (leverage), managers are granted additional stock options, consistent with optimal contracting and the empirical predictions of Choe (2001) and, more generally, the asset substitution hypothesis of Meyers (1977). Taken together, these results suggest that for some firms, the use of executive option may be efficient from the standpoint of shareholders.