Stock Options and Risk Samir Term Paper

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In these scenarios, stock options provide a powerful tool in which to properly align the goals of management with those of the firm

What exactly performance-oriented rewards are in regards stock options? To begin, options are not stock in its physical form but rather a claim to stock at a predetermined price. There are two key distinctions regarding this concept. First, stock options have an asymmetric payoff (see Chapter 2) and second they do not pay any dividends. Stocks, in regards to actual ownership, do pay dividends. These two key distinctions can create risk-taking behavior on the part of management because the value of options increases with the overall risk on the firm. The price of options also decreases with a large dividend increase. The more stable a company is in regards to its performance, the less valuable the option will become. Therefore, performance oriented rewards provide incentive for the company to increase risk while also having a corresponding decrease in dividends. Currently, dividend overall have decreased substantially relative to earnings (Fama and French, 1999). This, to be fair, may be a response to overall risk within the market as a whole, rather than risk in one particular firm. Wayne Guay, in his Financial Times article states that firms with very high growth opportunities tend to increase the granting of stock options (Guay, 1999). In turn, these "owners" take more risks to increase the value of the stock options of the firm. This action, by virtue of the risk inherent in it, causes many smaller growth firms to become insolvent and eventually bankrupt.

Further compounding the issue of performance oriented rewards and their relevance to shareholders is the evidence regarding risk. Is risk taking on the part of management desirable or undesirable on the part of shareholders? Who is to say what is risky in a shareholder population of thousands of owners. Managers who shun risk for example, may be overly conservative with their management of the firm. Consequently, these individuals will take fewer risks than are desired by shareholders (Lambert, Larcker and Verrecchia, 1991). This principal agent problem -- which is addressed in more detail in chapter 2 -- is compounded when managers have strong incentive not to take much risk. As discussed in more detail in the next chapter, management may not engage in growth activities due in part to their desire to remain in their position. In retrospect, there is research that provides strong incentive for and against risk taking through performance oriented rewards. As such, it is difficult to determine whether stock options encourage risky behavior on the part of management or not. Furthermore, it is difficult to ascertain if these actions would be harmful or shareholders in the long run. Examples given above show two contrasting positions regarding performance oriented rewards and their subsequent benefit to shareholders.

1.3 Research Question

In this thesis I have chosen to examine the link between stock options, and how both correspond to the inherent risk of a company. Share options and risk, as alluded to above, are now becoming more of a concern as the economic recovery continues to mull along. Shareholders are now more cognizant of the vast wealth and subsequent risk taking on the part of executives. Many contend that the pay received by many top-level executives is not commensurate with that of the value creation they provide to the company (Touryalai, 2012).

Over the years, stock options have become an integral aspect of an executive's overall compensation. What once was simply an added bonus for executives has now become the standard by which they are compensated. It is through these stock options that the propensity to incur additional risk is exacerbated. This is particularly true for executives in industries deemed essential for the proper functioning of the economy. Executives in industries such as financial services, automotive, and energy are more apt to increase risk due particularly to the concept of moral hazard.

A moral hazard occurs when there is an incentive for a person to take high or unusual risks in an attempt to grab at a profit while it is still possible to do so, say for example, before a contract is settled. As executives in these critical industries incur additional risk, there is seemingly no incentive to protect against the adverse economic consequences of their behavior. Since their industries are needed for the overall economy to function, these executives assume that a third party, usually the government, taxpayers, or private enterprise will incur the loss. Therefore, there is a link between stock options and how risky the firm's activities are.

If moral hazard is present because risk is embedded in a company, the possibility of profound consequences increases dramatically. The key themes within this dissertation are attributed primary to risk taking on the part of executives with vast amounts of stock options. In addition to moral hazard, aspects such as higher leverage ratios, negative NPV projects, and principal-agent complications all contribute to this risky behavior.

1.4 Chapter Structure

Due the wide and varied discussion around stock options and overall risk taking behavior of firms, the document attempts to hone in on three principles, which include the principal-agent problem, moral hazard, and asymmetric market information. These principles more than any other provide insights into stock options, and risk taking on the part of management. What I find interesting is that many of these topics have valid arguments for and against the prevailing sentiments of society. As mentioned briefly above both sides have valid examples, figures and knowledge to reinforce their arguments. With this document, we will focus on the core aspects of these arguments that include the principal-agent problem, moral hazard, and asymmetric market information. The document will first begin with an introduction, providing an overall synopsis of stock options, their prevalence, their appeal, and unintended consequences of providing them. Details on options in regards to risk are incorporated into the literature review in chapter 2. This section provides insights into the risk taking behavior of management with large amounts of stock based incentive compensation. Chapters 3 and 4 focus on the methodology and findings used throughout the document. Chapter 5 provides a critical analysis and conclusion of the information provided in chapters 2 through 4. This analysis is the result of the research conducted throughout the course of this document. It reflects an unbiased approach to stock options and the subsequent risk taking behaviors of management.

Chapter 2- Literature Review

In regards to options and risk three main themes emerge from the literature: the principal-agent problem, moral hazard, and asymmetric information. All three components directly relate to stock options and their subsequent risk. The first discussion will be centered on the principal-agent problem. This concept is arguable the most dominant of the three. It is difficult to ascertain or prove if management is acting in the best self-interest or if they are being prudent stewards of shareholder capital. Furthermore, the actions of management can be spun in a manner that may seem as though they are acting in accordance with shareholder mandates, but in actuality, their behavior is decidedly not aligned with shareholder interests.

Secondly, the discussion shifts towards the concept moral hazard. This notion pertains primarily to very large institutions that are necessary to the proper functioning of society. The concept behind moral hazard is the lack of incentive to stop risk because a company is protected from the consequences of such behavior. Lehman Brothers for example, didn't guard against the risk inherent in mortgage related activities. Lehman Brothers management believed they would be bailed out by the United States government. However, the company did not receive a bail out and shareholders ultimately paid a price for risk taking behavior of Lehman Brothers management.

Finally, the concept of asymmetric information is discussed in detail as it pertains primarily to the field of behavioral finance. In many instances the information used by the market to conduct research and make financial decisions may be flawed. Management may purposely withhold key developments and information in an effort to hide a material weakness in the firm. With the absence of this information, society values the company at a higher price than it otherwise would be, thus elevating option prices for executives. The excessive risk[continue]

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