Term Paper on "Stock Options and Risk"

Term Paper 10 pages (2900 words) Sources: 15

[EXCERPT] . . . .

Stock Options and Risk

"This study is a part of the Masters of Science programme. The college does not take any responsibility for the methods used, the findings nor the conclusions drawn."

This research study was conducted by during the time period June -- September in 2012 and is based on financial executives and their perceptions on executive stock options. The aim of the study was add value to previous studies conducted around the topic of executive stock options.

Does the management of a company take on more risk if they have stock options?

Aim/Objective of research:

Secondary data (literature review)

Find key arguments for and against executive stock options

Primary data (questionnaire)

Investigate whether the management of a company takes on more risk if they have stock options.

Investigate current financial executives perceptions on executive stock options

Methodology

For this study surveys were distributed to the participants. For the first two sections of the survey, analysis was supported by exploring the data parameters, such as measures of response frequency. The third and last section of the survey was an open-ended question, therefore a qualitative approach called constant comparative was used to analyse data.

Main Findings

The main result of this study is that both loss aversion and the bearing of risk in stock-based compensation structures do impact the risk-seeking behavior of managers.

This dissertation would not be possible without the support and guidance from XXXX. He has helped me to ask reflective questions along the way, as well as giving me valuable and constructive feedback until the very end. It is a great pleasure to thank XXXX who helped me write my dissertation successfully. Besides I would like to express my love and thankfulness to my family who have always supported me. Their love and moral support has given me strength to break through barriers and reach success in life.

Contents

Chapter 1 -- Introduction

71.1General Overview

91.2 Performance Oriented Rewards with particular emphasis on stock

121.3 Research Question

131.4 Chapter Structure

Chapter 2- Literature Review

162.2 Principal-Agent Problem

222.3 Asymmetric information

292.4 Moral Hazard

Chapter 3 -- Methodology

343.1 Method

353.2 Ethical considerations

353.3 Population/sample

353.4 Research Instrument

363.5 Fieldwork

373.6 Instrumentation

373.6.1 Questions related to performance-oriented compensation

383.6.2 Question related to stock options

Chapter 4 -- Results

394.1 Introduction to Results

404.2 Research Findings

404.2.1 Demographics of respondents

404.2.2 Analysis of responses to questionnaire items

404.2.2.1 Results for the performance-oriented compensation category

414.2.2.2 Results for the stock options category

434.2.2.3 Results for the stewardship category

444.2.2.4 Results for the efficient market category

454.2.2.5 Results for the general attitude category

464.2.3 Analysis of comments in open-ended questions

Chapter 5 -- Conclusion

485.1. Discussion

485.1.1 Secondary Data

495.1.2 Primary Data

505.2 Limitations and recommendations for future research

515.3 Research conclusion

References

Appendix 1: Letter of Introduction and Questionnaire

Appendix 2 -- Open-ended answers from questionnaire

Appendix 3: Correspondence with CEO

Chapter 1 -- Introduction

1.1 General Overview

An issue arising within public domain is that of compensation and its repercussions on overall society. Over the past 3 decades executive compensation has ballooned while the average worker continues to see only modest gains in income. This disproportionate disparity between executive compensation and that of the average American family provides a solid foundation by which to examine the merits of stock options.

The value of stock options now dwarfs the actual value to shareholders. In accordance with this growing demand for stock options on the part of executives, there has subsequently been an increase in academic literature that has emerged. This literature is interesting its views for and against stock options. Both which are very valid in regards to their overall claims. What I find interesting, particularly in the context of our current economic conditions, is the viability of stock options to increase firm value. Are options indeed a tool to increase value or are they simply a tool for the wealthy to accumulate more wealth without a corresponding increase in firm value. This topic is of particular interest given the "Occupy Wall street" and other anti-banking sentiments that have developed over the past 5 years. Stock options have been at the forefront on this anti-banking sentiments as unemployment, wages, and home ownership have decreased while large organizations continue to provide stock options to the executives. This is particularly true of banking organizations, which the public perceives as having disproportionately created the fiscal crisis of 2008. Others however, believe stock options were needed at precisely this time so executives have the incentive to correct the errors of their respective firms in a timely manner. These pundits believe that societal sentiments are misplaced on banking. More emphasis, they believe should be placed on personal decision making in regards to the crisis, not stock options and compensation. I find both arguments appealing; I have devoted a significant amount of time to consider both arguments within the overall context of employee compensation.

This study evaluates whether these stock options align with shareholder value. This dissertation argues that this fundamental theory is flawed. In some respects, stock ownership does indeed align company goals with those of management and stockholders. In other instances, as I will allude to in this document, stock options encourage management to take excessive risks to temporarily inflate the value attributed to each share of the company. This excessive behavior on the part of management usually is obtained through high-risk propensity on the part of the overall company. This higher risk, by virtue of the uncertainty involved in risk, can create the potential for devastating loses. Add excessive leverage to the equation, and companies once thought to be stable can instantly become insolvent (Bear Sterns, Long-Term Capital Management, Washington Mutual, and Lehman Brothers all come to mind).

Numerous examples, occurring primarily during the financial crisis assert this theory. Bank of America's acquisition of Countrywide Financial was an extremely risky endeavor that cost shareholders nearly half the market valuation of their company. During the crisis however, executives, heightened the value of their stock in the short-term. Long after their departure, however, shareholders were left with a significantly devalued company. Therefore, I assert that stock options with no potential for downside risk on the part of management encourage risky behavior that ultimately undermines shareholders' interests.

There is support in the research for the idea that corporations may not award stock options to executive in the most optimal fashion. New executives are likely to receive particularly large stock option awards, presumably because of the impact of executive decisions on firm value (Yermack, 1994). This is one of several variables that may influence the short-term consideration of executives toward their compensation. Another is that boards of directors are unlikely to pay substantive long-term compensation to executives as their retirement nears (Yermack, 1994). Further, as firm size increases, it becomes more difficult for boards to monitor managerial performance directly and fixed administrative costs for the implementation of compensation plans are generally incurred (Yermack, 1994). The relation between new stock option awards and the current performance of a firm is roughly zero, as the coefficient is generally of a very small magnitude (Yermack, 1994). At the time of Yermack's research -- early 1990s -- the author concluded that "contingent pay instruments used in CEO compensation are not well designed to reduce agency costs and are not awarded with great sensitivity to firms' financial environments" (1994, p. 29).

Stock options however, do have merit in regards to objective alignment when used appropriately. A stock option in a conservatively run franchise does indeed encourage value-enriching behavior. This is particularly true if shareholders act as actual owners of the company and, in so doing, are vulnerable to downside risk. Proper oversight in regards to acquisitions, mergers, and capital expenditures also increases the effectiveness of stock options.

1.2 Performance Oriented Rewards with particular emphasis on stock

Performance-oriented reward systems are most often directed at executive compensation, and are used to align executive compensation with the overall performance of a business unit or the firm. In performance-based systems, executive compensation in the form of salary adjustments, awards, and bonuses commonly show a linear relationship to performance. In fact, strong positive correlations between executive performance ratings and executive performance compensation in companies using a performance-based approach can typically be demonstrated through the use of the Pearson correlation coefficient metric.

Stock options are used primarily to entice management when capital is not widely available. This is true particularly for young, emerging companies who have little capital, but would like to attract top talent. Through stock options, talented management can be attracted to the company without spending a large amount on a concrete salary. This is advantageous to both the firm and the individual manager. The firm obtains talent that can subsequently be used to grow the business. The goals and objectives of the firm are aligned as the manager is paid in stock options. The manager is also pleased as if the job is conducting in a conservative manner, he can increase the value of… READ MORE

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