The nonlinear relation between financing decisions and option compensation
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The nonlinear relation between financing decisions and option compensation Yoon K. Choi1 · Seung Hun Han2 · Seongjae Mun2
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Recent studies argue that CEO option compensation affects executives’ behavior toward risk. Specifically, the literature provides seemingly conflicting evidence regarding the impact of equity compensation (particularly option holding) on financing activities. We propose and test a nonlinear (e.g., inverted U-shaped) relation between corporate borrowing and option compensation. Consistent with our hypothesis, we empirically show that, in the low range of the option vega, a firm’s debt ratio increases as the option vega increases. However, in the high range of the option vega, we find the opposite relation. Our explanation is based on the contrasting effects of option compensation on managerial incentives toward risk. The positive wealth effect on leverage arises from the convexity of the option compensation, while a negative risk-premium effect exists due to managerial risk aversion. This reconciles the conflicting relation between leverage and option compensation that is often observed in the literature. Keywords Corporate borrowing · Option compensation · Option vega · Risk aversion JEL Classification G32 · J33
1 Introduction Option compensation has been a critical element of executive compensation for the last few decades because it is perceived to reduce agency problems by increasing the alignment between managerial and shareholder interests (Hall and Liebman 1998; Aggarwal * Yoon K. Choi [email protected] Seung Hun Han [email protected] Seongjae Mun [email protected] 1
Department of Finance, College of Business Administration, University of Central Florida, Orlando, FL 32816, USA
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School of Business and Technology Management, College of Business, Korea Advanced Institute of Science and Technology, Daejeon, South Korea
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and Samwick 1999). However, recent studies present two conflicting arguments regarding the direction that CEO option compensation affects executives’ behavior toward risk. One argument is that given the positive relation between the option value and underlying stock volatility, a manager who is compensated with option grants tends to take on more risky (volatility-increasing) decisions such as financing decisions to increase his/her wealth (see Guay 1999; Coles et al. 2006; Chava and Purnannandam 2010).1 The other argument is that risk-averse managers are also concerned about their exposure to firm-specific risk arising from equity compensation, and thus have incentives to reduce the risk exposure such as debt levels. For example, Guay (1999) and Lewellen (2006) show a negative relation between debt financing and option convexity. Given this seemingly conflicting evidence regarding the impact of equity compensation (especially option holding) on financing activities, we propose and test a hypothesis that, all other things being equal, the rel
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