The Incentive Effect of Executive Stock Options on Corporate Investment Strategy: the Evidence of Strategic Alliance

A distinctive feature of stock options is that they create incentives for managers to take more risks. For a sample of 12,071 firm-year observations over 1992-2003, we find that the risk-taking incentives of executive stock options (the sensitivity of ESO values to stock return volatility) are significantly associated with greater risk-taking behavior, measured by corporate alliances, in the following year. Furthermore, in order to examine the extent to which incentives increase executives’ risk taking, we classify alliances according to the different risk level involved, based on the exploration-exploitation framework of March (1991), and we find that the risk-taking incentives of ESOs encourage managers to undertake more exploitation rather than exploration alliances. With regard to the future firm performance after entering into alliances, we find a positive association between ESO risk-taking incentives and subsequent operating performance. When examining different risk level alliances, the positive correlation of ESO risk-taking incentives to firm performance is significantly greater in the case of exploitation alliance rather than exploration alliances. Overall, our results not only are consistent with the idea that ESOs provide executives with incentives to conduct the value-increasing alliances, but also explain the dispute in the finance literature regarding the effectiveness of ESOs in lowering the agency problem of underinvestment.