Stock Market’s Rise May Be Producing Crop of Very Cautious CEOs, Study of Stock Options Suggests

Introducing further complications are two other factors — 1) the growing tendency of CEOs to hedge gains through financial instruments (called put options) that guarantee a minimum sale price of stocks covered by company option grants and 2) the increasing vulnerability of CEOs to dismissal.

Although sometimes criticized as bets against their own firms, executive investment hedging has now become fairly commonplace, and the new research finds it has oddly contradictory effects on risk-taking: it accentuates the drag of current wealth but intensifies the pull of prospective wealth. Puzzling though the former result may be, the latter is in accord with the professors’ expectation that “the pursuit of additional wealth is further encouraged once the downside risk to future wealth is ameliorated through hedging.”

Vulnerability too is a growing trend. As the study notes, “Given that approximately half of CEOs are replaced every five years and the often well-publicized nature of CEO replacement by the media, a perception of vulnerability to dismissal by CEOs is likely to be ubiquitous.” Equating vulnerability with three consecutive years of share-price decline plus three years of decline in return on assets, the professors find that it erodes the negative effect of current wealth while neither increasing or decreasing the pull of prospective wealth. “This implies,” they write, “that highly entrenched CEOs — who by definition are less vulnerable to dismissal — are more likely to be influenced by current wealth than prospective wealth, seeking fewer risky investment alternatives as a result.” Further compounding this effect, they add, is that “entrenched CEOs are likely to have spent longer periods in the employment of the firm and therefore are also more likely to have had the opportunity to accumulate wealth in their stock options.”

A major, even dominant, component of executive compensation since the 1950s, stock options were originally proposed as a way to encourage strategic risk-taking. The idea was that it would align the interests of typically risk-averse CEOs, whose wealth is largely bound up with a single firm, with those of typically risk-neutral shareholders, whose holdings are likely to be spread over many companies.

The study’s findings emerge from data collected over 14 years (1996-2009) from all publicly traded manufacturing firms in a large executive-compensation database, with option-trading data being analyzed for 9,143 CEO-years. Strategic risk-taking was determined through three factors — 1) companies’ annual spending on research and development; 2) their spending on property plant, and equipment; and 3) changes in the amount of their long-term debt.