CEOs Motivated To Take More Business Risks When Compensation Includes Stock Options: McKinsey Quarterly

From McKinsey Quarterly, "Does your CEO compensation plan provide the right incentives? Few boards look at how the CEO’s total wealth invested in the company changes as stock prices fluctuate. They could—and they should." by David F. Larcker and Brian Tayan, April 2012:

Volatility as a window on risk

We can take the analysis one step further and plot the change in expected CEO wealth against changes in stock price volatility. This additional detail can paint a stark picture of the degree to which boards are encouraging risk taking.

The foundation for this analysis is the incentives associated with stock options and grants: If a CEO’s investment portfolio is heavily weighted toward options, he or she is motivated to take on risky investments because the present value of the options package increases as volatility rises in step with a more ambitious and potentially uncertain strategy. If, on the other hand, the investment portfolio is composed entirely of stock, the CEO is not rewarded for volatility, creating an incentive to take on safer projects with lower risk and return. [Emphasis added]

This dynamic is illustrated by two pharmaceutical companies shown in Exhibit 2. The CEO of company A holds only direct stock investments and restricted shares, so the executive’s payout function is essentially a flat line and is unaffected by a volatile stock price. The CEO of company B, by contrast, receives a significant share of compensation in stock options, so the executive’s payout rises dramatically with greater volatility, as shown by the upwardly sloping line.