Executive stock options: Risk taking, contracting, and abnormal returns

Essay one examines the relationship between executive stock options and leverage and the interaction with institutional ownership. Agency theory has held that options granted to executives should resolve some conflicts between managers and stockholders (Jensen and Meckling, 1976). Yet recent events highlight the additional and perverse incentives that executive stock options can create. Prior research documents a positive contemporaneous relationship between options and leverage. I explicitly test for a causal relationship between these two. I find that increases in executive options cause financial risk taking when there is low institutional ownership. For high institutional ownership, I find that this is not the case. Rather, following increases in leverage, managers are granted additional stock options to re-align incentives.; Essay two examines the relationship between the structure of executive compensation and risk taking behavior in the banking industry. First, it analyzes the relationship between managerial option compensation and bank capital-asset ratios. Second, it analyzes whether the pay-for-risk incentive (Vega) created by executive stock options induces managers to increase other types of risk including credit risk, interest rate risk, operational risk and liquidity risk. I find a consistent upward trend in Vega, and a consistent downward trend Delta. I find that Delta is related to bank capital-asset ratios. I also find that Vega is positively associated with measures of credit risk and negatively associated with measure of bank liquidity. These results suggest bank managers respond to risk incentives created by option compensation.; Essay three is an investigation of the profitability of a trading strategy which exploits the relationship between executive stock option grants and stock returns. I suggest a method by which investors can take advantage of the return smile surrounding option grants. I rely on SEC mandated, after-the-fact disclosures of option grant dates to identify a sub-sample of firms with fixed, annual option grant dates. I take a short position in these firms' stocks just before the anticipated, but unobservable, option grant, and reverse that position immediately after the grant. The abnormal returns from this trading strategy are in excess of 2.5% over the 100-day holding period.