In the October/November issue of the Academy of Management Journal, the authors note that the basic purpose of options has been to promote managerial aggressiveness in top executives, even if they sometimes led them “to undertake large-scale risky investments that tended to deliver extreme company performance.” What was not envisioned, they write, “was that the extreme performance delivered by option-loaded CEOs was more likely to be in the form of big losses than big gains.”
I’m not sure of their premise, i.e. “the basic purpose of options has been to promote managerial aggressiveness”. The purpose of options is and was to create improved alignment between the employees and the shareholders. A shareholder may want a more agressive management, i.e. higher risk and increase volatility, but only if that shareholder is well diversified so he can temper that with the rest of his portfolio. Options tend to create higher risk taking since the option holder, unlike the shareholder, doesn’t actually have capital at risk.
It’s fascinating to me how capital/shareholders may be perfectly happy to have their managers take risks that will kill the company; since limited liability shelters them from the full magnitude of the down side while they are likely to get much of the upside. So the pattern seen above maybe what the owners want.
Update: Paul Krugman makes an analogous moral hazard argument.
See also the pirate metaphor as applied to limited liablity.
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