The Effect of Option Grants on Managerial Risk Taking: A Review

Abstract

This article presents a systematic review of the theoretical and empirical literature on option grants and managerial risk taking. One of the objectives is the motivation of further research on the topic. Risk-averse managers hold less diversified portfolios and, thus, tend to take less risk than optimal for shareholders. More option grants may encourage risk taking and result in higher firm value or alternatively increase the sensitivity of wealth to stock-price fluctuations mitigating overall risk-taking incentives. The net effect of options on risk-taking behavior is, therefore, ambiguous and calls for more empirical investigation. This is crucial for fiscal policymaking and regulation reforms. Yet, establishing a causal link between option granting and managerial risk taking has been challenging due to reverse causality, omitted correlated variables and measurement errors. In this review, we revisit the VegaDelta question by synthesizing the relevant research in economics, finance and accounting. We find that the empirical literature has successfully utilized natural experiments (e.g., regulation changes) to better establish causality, even though some mixed results are also documented. Finally, we also emphasize potential future research avenues especially relating to accounting disclosure, earnings management and tax policy.