75 NTU Management Review Vol. 31 No. 1 Apr. 2021 2. Literature and Hypotheses 2.1 ESOs, Risk-Taking, and Cash Holdings Managers who are granted ESOs are supposed to undertake risky and value-increasing investments that otherwise they would do less than shareholders’ expectation due to their risk aversion. ESOs can align the interest of managers with that of shareholders. Particularly, the value of options increases alongside the volatility of stock return. Haugen and Senbet (1981) analytically demonstrate the payoff of ESOs can mitigate managers’ risk aversion. Smith and Stulz (1985) emphasize solving agency problems with ESOs can maximize the market value of firms. Theoretically, the convexity of managers’ wealth varies not only with the sensitivity of their wealth to the volatility of stock return (vega), but also with the sensitivity of their wealth to the changes in stock prices (delta). According to extant literature, the positive relation between vega and managerial risk taking is well demonstrated (Coles et al., 2006; Low, 2009), but the effect of delta on corporate risk-taking is ambiguous. This is probably because delta might magnify the impact of changes in the stock price on the wealth of managers and could deteriorate managers’ risk aversion. Prior studies also show similar evidence that ESOs are not necessary to increase managers’ risk taking unless the utility of managers’ wealth increases (Carpenter, 2000; Ross, 2004; Lewellen, 2006). Overall, empirical findings support the positive effect of ESOs on managerial risk taking, mainly due to the convexity of ESOs (vega). Further, to better establish the causal relation between ESOs (vega) and corporate risk taking, some studies distinguish systematic and idiosyncratic risks from managers’ perspectives (e.g., Tian, 2004; Duan and Wei, 2005). Armstrong and Vashishtha (2012) posit vega provides risk-averse managers incentives to increase total risk mainly through systematic risk, rather than through idiosyncratic risk. This is because managers can hedge systematic risk by trading the market portfolio; therefore, they consider firms can receive a higher expected stock return by taking systematic risk. Chen et al. (2014) verify this argument by showing ESOs encourage more product innovations than development innovations. However, risk taking from idiosyncratic risk is often important for firms to develop their long-term growth such as R&D investments. Pástor and Veronesi (2009) also suggest corporate R&D activities and idiosyncratic risk taking are highly associated. The issue then becomes how ESOs can really encourage the managerial risk taking associated
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