Executive stock options, the agency problem, and the risk-averse investor
Date
2009-10
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Abstract
This paper evaluates whether the provision of Executive Stock Options (ESO) is truly an effective tool in mitigating the Agency problem. Most financial references suggest that the best way to align the executive's interest with that of the stakeholder's is to compensate them with stocks since these will give them a stake with the company. In the last decade, such practice has gained much popularity. Specifically, from the years 1992-2004, stock option compensation has increased by almost 200% as opposed to fixed salary compensation which increased only 67%. Such excessive compensation has gained much attention from the public, especially since there has been no quantitative proof supporting the theory that ESO compensation leads to higher productivity and profitability. Much speculation has been made about how ESOs actually result to higher risk taking on the part of the agent, contrary to what theory states. A number of papers have been written on this topic but none have been able to show quantitatively the correlation between the two factors while taking into consideration other significant elements. This paper would be the first to present working regression models that consider the effects of both financial and macroeconomic factors.
Least Squares regression is used on four different pooled models, which include determinants such as credit default swap, inflation, and gross domestic product growth, to reveal any significant effects of ESO on stock price volatility, company profit, profit volatility, and magnitude of change in stock price respectively. A Logistics regression is used on the last pooled model, which also includes the previously stated determinants, to reveal any significant effects of ESO on the company's probability of loss or bankruptcy. The five regression models are applied to two sets of data, the first is composed of 57 non-financial US firms and the second of 59 financial US firms, both for the period of 2000 to 2008.
Estimation results derived from the pooled least squares and logistics regression models reveal that ESO is significant in affecting stock price volatility, profit volatility and the magnitude of change in stock price, when it comes to non-financial firms. Auxiliary regressions also show that although ESO does not directly affect the firm's probability of loss or bankruptcy, it does affect it indirectly through stock price volatility. Also, profit improvement has no relation to the provision of ESO. When executives receive options, they are given greater incentive to take on riskier investments. In terms of financial firms, estimation results reveal that ESO is significant in affecting stock price volatility, company profit, and probability of loss or bankruptcy. Auxiliary regressions also show that ESO affects the magnitude of change in stock price and profit volatility indirectly, Overall, the results are consistent with the hypothesis that ESO does aggravate the Agency problem whether through higher company stock price and profit volatility, greater actual change in company stock price, and/or increased probability of company loss and bankruptcy. However, it is important to note that in the case of financial firms, ESO does aid in improving company profits but at the price of higher company risk.
Based on the empirical results of this study, companies should avoid compensation in the form of options as these actually intensify the Agency problem. Companies should instead focus on compensating their executives through fixed salaries or debt. Finally, any risk-averse investor can now use the ESO as an added measure for risk, in selecting which companies to include in his investment portfolio.
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Keywords
Executive stock option, Agency problem, Risk-averse investor, Corporate governance, Risk management