Swinging for the Fences: Executive Reactions to Quasi-Random Option Grants

The financial crisis renewed interest in the relation between pay-for-performance compensation and risk taking incentives. We examine whether paying top executives with options induces them to take more risk. To identify the causal effect of options, we exploit two distinct sources of variation in option compensation that arise from institutional features of multi-year grant cycles. We find that a 10 percent increase in the value of new options granted leads to a 3-6 percent increase in firm equity volatility. This increase in risk is largely driven by an increase in leverage and is stronger in the financial and high-tech sectors. We also find that an increase in stock options leads to lower dividend growth with mixed effects on investment and firm profitability. JEL Classification: M52, J33, G32, G34