Does size affect the relation between option compensation and managerial risk taking? Evidence from Canadian listed companies

• Author: Atreya Chakraborty,Shahbaz Sheikh,Lucia Silva Gao
• Published date: 01 January 2019
• Date: 01 January 2019
• DOI: http://doi.org/10.1002/ijfe.1646

RESEARCH ARTICLE

Does size affect the relation between option compensation

and managerial risk taking? Evidence from Canadian listed

companies

Atreya Chakraborty

1

| Lucia Silva Gao

1

| Shahbaz Sheikh

2

1

College of Management, University of

Massachusetts, Boston, Massachusetts

2

Dan Department of Management and

Organizational Studies, The University of

Western Ontario, London, Ontario,

Canada

Correspondence

Lucia Silva Gao, Associate Professor,

College of Management, University of

Massachusetts, Boston, MA.

Email: lucia.silva‐gao@umb.edu

Abstract

We examine the effect of CEO option compensation on firm risk in Canadian

firms listed on the S&P/TSX index. Results show that there is a robust size

effect. Option compensation has a positive and significant effect on firm risk

only in small firms and no significant effect in large firms. Moreover, option

compensation has no significant effect on firm risk in cross‐listed firms, but

within the sample of cross‐listed firms option compensation has a positive and

significant effect in small firms only. Overall, our results suggest that CEO com-

pensation is more effective in encouraging risk taking in small Canadian firms.

KEYWORDS

cross‐listing, executive compensation, firm size, option compensation, risk taking

1|INTRODUCTION

There is a growing literature that studies how managerial

compensation, particularly option‐based compensation,

affects managerial risk taking. The agency theory (Jensen

& Meckling, 1976; Jensen & Murphy, 1990; Holmstrom,

1979) postulates that linking managerial pay to firm per-

formance using options encourages risk‐averse managers

to increase firm risk. Several studies find a positive asso-

ciation between the convexity of option compensation

and various measures of firm risk (Tufano, 1996; Guay,

1999; Rajgopal & Shevlin, 2002; Coles, Daniel, & Naveen,

2006; Chava and Purnandam, 2010). However, Lambert,

Larcker, and Verrecchia (1991), Carpenter (2000), and

Ross (2004) argue that options do not always increase

managerial risk taking and, in some cases, may even lead

risk‐averse managers to reduce risk taking.

Most studies that examine the effect of CEO option

compensation on managerial risk taking use data on large

U.S. corporations. In this study, we use a sample of Cana-

dian companies listed on the Toronto Stock Exchange

(TSX). There are a couple of distinct features in Canadian

companies that differentiate them from their U.S.

counterparts. First, although Canadian companies are

culturally similar to U.S. companies, they are smaller.

Second, a significant number of Canadian companies

(approximately 30% of TSX listed companies) cross‐list

on a U.S. stock exchange and compete for the same man-

agerial talent. These peculiar characteristics of Canadian

companies provide a unique opportunity to examine if

and how CEO option compensation affects managerial

risk taking. It also provides an opportunity to see if firm

size plays any role in this relation, as the Canadian

cross‐listed companies are larger compared to the Cana-

dian companies that are not cross‐listed. Moreover,

cross‐listed companies have to comply with more strin-

gent regulations, disclosure requirements, and capital

market rules. Therefore, the differences in the financial

markets environment provide another opportunity to

examine if and how size affects the relation between

option compensation and managerial risk taking.

Using data on all companies included in the S&P/TSX

index for the period 2009–2014, we find that the propor-

tion of CEO options compensation is positively related

to managerial risk taking measured by stock return vola-

tility. However, this relation is driven by a robust size

Received: 20 August 2017 Revised: 15 February 2018 Accepted: 26 June 2018

DOI: 10.1002/ijfe.1646

20 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:20–32.wileyonlinelibrary.com/journal/ijfe