The significance of stock options as a component of executive compensation has fluctuated dramatically over the past decade. The purpose of this study is to investigate determinants of the effectiveness of stock option grants. These option grants are considered to be effective if they accomplish their intended role of enhancing firm value by inducing risk-taking behavior. Using data from 2,349 firms that granted stock options to their Chief Executive Officer (CEO) between 1992 and 2001, the relationship between the options granted and subsequent firm value was examined. This study found no universal positive association between option grants and firm value. However, CEO incentive equilibrium, defined as stability in the CEO’s stock and option portfolio sensitivity to stock price, was found to influence the association between stock option grants and firm value. The positive association between grants and firm value was evidenced for the sub-sample of firms that demonstrate disequilibrium in CEO incentives. This was not the case, however, for the CEO incentive equilibrium sub-sample. This finding indicates that the positive valuation impact of stock option grants is highest for those firms that demonstrate a trend of increasing CEO portfolio sensitivity to stock price. High CEO portfolio sensitivity to equity risk was not found to interact with grant sensitivity to equity risk in a manner that reduces firm value. Thus, this study did not find support for the hypothesis that, ceteris paribus, grants further reduce CEO diversification, and interact with portfolio sensitivity to reduce incentives for risk-taking. Consistent with Lambert, Larcker and Verrecchia (1991), however, a high level of uncorrelated wealth is found to interact with grant sensitivity to equity risk so as to increase the positive impact of grant sensitivity on firm value.

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The convex pay-off structure of executive stock options (ESO) incentivizes CEOs to increase their firm stock-return volatility, thereby increasing their wealth in option portfolio. In this paper, I address two research questions. I first test if this managerial incentive induces executives to take on more risky projects in R&D that increases stock- return volatility, hence, boosting their personal wealth. I derive vega to measure managerial incentive, and vega is a dollar change in ESO for a 0.01 change in stock- return volatility. I find that there is a positive and statistically significant relationship between vega and R&D investment, which suggests that managers whose wealth is closely tied to stock options are more incentivized to invest in risky R&D projects to increase their wealth and stock-return volatility. This result is statistically significant and robust after adjusting for inflation and controlling for firm and industry-fixed effects. With this finding, I proceed to test if managerial risk-taking incentive for R&D investments translate to future earnings. Lev and Sougiannis (1996) establish that future earnings is a function of both tangible and intangible assets, and R&D increases with firm’s subsequent earnings. Since R&D spending changes with managerial incentive, I test if the interactive variable of vega and R&D has a positive effect on firm’s future earnings. I find that managerial incentive for undertaking R&D investments has a positive and statistically significant association with future earnings under industry-fixed effects specifications. When controlling for firm-fixed effects, the result yielded similar results to that of industry-fixed effects, but with less statistical significance. Lastly, for robustness check, I run the regression with a balanced panel data of tenured-CEOs, who stay with the firm for five years. I find that the result is positive and statistically significant for industry-fixed effects. However, for firm-fixed effects, I only find statistical significance at year t+k (k=3). This suggests that the realization of R&D investment to future earnings is not prevalent throughout all years when R&D decisions are made by incentivized, long-standing CEOs.