High Return, High Risk - Does Stock Option Based CEO Compensation Encourage Risk Taking

This study, through empirical evidence of 3,081 US firms during the period of 1992-2009, shows a strong causal relation between different CEO compensation components and firms’ investment policy and firm risk. Specifically, the proportion of CEO option-based compensation is positively and significantly associated with firm’s R&D expenditures and firm focus, while the proportion of cash-based and restricted stock compensation are negatively and significantly related. Such results are robust across alternative measures and statistical methodology. Furthermore, there is a non-linear relation between CEO option pay level and R&D investment discovered with practical implications. Finally, following the implementation of FAS 123R in 2005, new evidence indicates that option-based compensation remains as an effective motivation and even becomes a more efficient incentive for CEO to take risk on R&D investment and firm focus.