72 Executive Stock Options, Corporate Cash Holdings and M&A Decisions 1. Introduction ESOs are designed to mitigate the agency problem between managers and shareholders because ESOs link executive compensation with firm risk in addition to stock value (e.g., Haugen and Senbet, 1981; Smith and Stulz, 1985; Guay, 1999; Chen and Lin, 2019). While prior studies show the positive effect of the risk incentive of ESOs (vega) on firm risk (Coles, Daniel, and Naveen, 2006; Low, 2009; Armstrong and Vashishtha, 2012), some studies also find the risk taking induced by ESOs is more associated with systematic risk than with idiosyncratic risk because managers can hedge systematic risk by trading the market portfolio (Armstrong and Vashishtha, 2012; Chen, Chen, and Chu, 2014). This literature suggests CEOs with high ESO compensation could give up a valueincreasing investment with idiosyncratic risk if there is an alternative mainly associated with systematic risk. However, investments with greater idiosyncratic risk may usually be more critical to a firm’s long-term development such as research and development (R&D) investments (Pástor and Veronesi, 2009). Accordingly, an open question is how the risk incentive of ESOs can create value for shareholders by inducing managers to undertake investments with a certain level of idiosyncratic risk in addition to the systematic risk when managers hesitate to conduct idiosyncratic risk-taking. An important factor to consider with a firm’s idiosyncratic risk is its corporate cash holdings. Firms with higher cash flow risk due to idiosyncratic risk tend to keep greater cash holdings for precautionary reasons (Opler, Pinkowitz, Stulz, and Williamson, 1999; Bates, Kahle, and Stulz, 2009). When firms hold larger cash assets, they are more capable of undertaking risky investments because large cash holdings can serve as a buffer to protect themselves from unexpected shocks or uncertainty. Accordingly, we argue CEOs with high vega compensation would be more willing to increase firm value by undertaking investments with greater idiosyncratic risk if they have a high level of cash holdings on hand. Nevertheless, Liu and Mauer (2011) investigate the incentive effects of ESOs on cash holdings and find CEOs with high vega compensation tend to hold high cash assets due to the requirement of liquidity covenant instead of a financing need for growth opportunities, implying the exacerbation in the conflict between shareholders and debtholders. Given ESOs are granted to mitigate agency problems between shareholders and managers, an unclear issue arises, that is, why the risk incentive compensation (vega) would induce managers to increase cash for the benefits of debt holders at the expense of shareholders?
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