Stock options are a critical element of CEO compensation -- making up one quarter of total pay for executives these days. But what does that mean for the risk profiles of the companies those CEOs lead? At the heart of that question are two opposing forces: There is a risk-tempering aspect to options, because when those options are "in the money" -- meaning the exercise price is less than the current market price -- the value of those options moves in line with the stock price. That tends to dampen risk taking because CEOs want to preserve the value of those options.
At the same time, however, the downside of risk taking is limited because once the options are worth zero, they do not decline further in value if the stock price falls. And that limited downside increases the tendency to take on risk. A recent paper co-authored by Wharton finance professor Todd A. Gormley studied this issue by examining what steps CEOs took when hit with a sudden increase in business risk. The finding: The overall impact of options is an increase in risk taking by company leaders.
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