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The inclusion of fixed effects does not change our basic finding, though it does reduce the magnitude of the coefficient considerably. Now wealth elasticity predicts volatility with a coefficient of .030 (t-statistic of 4.39). The statistical significance is still strong; the size and precision of our data set enables us to obtain relatively small standard errors. A key issue is the interpretation of the economic significance of the coefficient. There is certainly a plausible argument to be made that the economic impact is small. Multiplying typical CEO wealth elasticities for 1995 by the .03 coefficient gives results in the range .005-.01 | First draft October 1999 This draft March 2000 Preliminary Comments welcome. Please do not circulate DO EXECUTIVE STOCK OPTIONS ENCOURAGE RISK-TAKING Randolph B. Cohen Brian J. Hall and Luis M. Viceira Graduate School of Business Administration Harvard University Boston MA 02163 USA Correspondence Randolph Cohen 365 Morgan Hall Harvard Business School Boston MA USA phone 617-495-6674 fax 617-496-6592 email rcohen@hbs.edu. We would like to thank Jeff Liebman and seminar participants at Harvard Business School for their valuable suggestions. We also thank Salim Ahmed for excellent research assistance and the Division of Research at the Harvard Business School for funding this research project. DO EXECUTIVE STOCK OPTIONS ENCOURAGE RISK-TAKING Abstract Executive stock options create incentives for executives to manage firms in ways that maximize firm market value. Since options increase in value with the volatility of the underlying stock executive stock options provide managers with incentives to take actions that increase firm risk. We find that executives respond to these incentives. There is a statistically significant relationship between increases in option holdings by executives and subsequent increases in firm risk. This relationship is robust to the inclusion of fixed effects year effects and a variety of other controls and does not seem to be driven by reverse causality. However the estimated effect on risk-taking is small and we do not find a negative or positive market response to option-induced risk-taking. In sum although options appear to increase firm risk there is no evidence that this effect is either large or damaging to shareholders. Keywords executive compensation executive stock options volatility leverage. JEL classification codes G31 G34 During the past 20 years executive stock options have grown from a trivial piece of executive pay to the largest single component. Indeed for many top executives the value of annual stock option grants swamp .
