Thursday, December 12, 2013

Stock options as payment can lead to high risk behavior

In reading an a paper called "Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking"

A recent paper co-authored by Wharton finance professor Todd A. Gormley studied this issue by examining what steps CEOs took when hit with a sudden increase in business risk.

The research is laid out in a new paper, "CEO Compensation and Corporate Risk Taking: Evidence from a Natural Experiment," by Gormley, David Matsa, a professor at Northwestern University's Kellogg School of Management, and Todd Milbourn, a professor at Olin Business School at Washington University in St. Louis. "Options do have an effect on risk taking," Gormley says. "That is something that should be factored into compensation structure by boards of directors."

I was looking for further information to validate my points mentioned in my previous comment.  It is clear that managers are effected by the knowledge of being compensated with stock options.  It of course also is away to appraise their performance.  It can be an incentive to work, harder and smarter.  However, in a public traded company, millions of dollars can be made in stock options over a very short period of time.  It is great to think that everyone will work hard and ethically while adhering to the company mission statement but we can see from recent disasters on Wall Street that this is just not always true.  One of the major challenges, in my option, for public traded companies, is to tie incentive pay to long term company goals as well as short term objectives. 
So why not just assign options to managers that will expire in 5 years?  The options can rise and fall daily even if they are not due to expire for long periods of time.  However, it is less likely to see a serious move in long term call options or LEAPS until you move closer and closer to the expiration date.  Using long term options as motivating strategy will not work in the short term.  There will be not enough incentive to effect short term performance.  It may allow for more ethical and better long term decisions but the challenge then would be one of how to retain top talent.  There will always be someone ready to take away an under paid manager with outstanding credentials and their will always be companies willing to take the risk of having shorter term stock options be part of the compensations package. 
Also, the evaluation will typically be good if the short term earnings and growth are good for the company.  Deciphering between what is good for the short term of the manager and what is good for the company long term is a difficult issue.  If the company stock does not move or goes down it is likely the manager will get poor reviews, even if he was doing what was prudent for the long term.

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