MARCO TEÓRICO
CONTRA INCENDIO
3.5 MÉTODOS DE SUPRESIÓN UTILIZADOS EN LA PROTECCIÓN CONTRA INCENDIOS.
In contrast to pursuing shareholder value maximisation, managers can use derivatives for risk management driven by the objective of maximising managerial wealth. One reason for such managerial behaviour is the inherent divergence in managers’ and shareholders’ risk preferences. This in turn arises from managers’ holding relatively undiversified portfolios and having their human capital and sources of monetary wealth being concentrated in their employer firms. The concentration of managerial wealth portfolio in their employer firms, contrasts with the portfolios of external shareholders, who are able to diversify their investment portfolios across multiple firms and thus to eliminate any firm specific, idiosyncratic risk. As a result, managers, as agents, tend to be more risk averse than the shareholders (principals), whom they represent (Smith and Stulz, 1985). Managerial risk aversion may be manifested in managers’ sub-optimal risk management and/or investment choices (Smith and Stulz, 1985). Managers could impose agency costs, for example, by engaging in excessive or full cover hedging (i.e. beyond the level that maximises risk neutral shareholder value) with the cost of excessive hedging eroding firm value.
One mode of mitigating such agency conflict is through the design of executive compensation contracts. Executive compensation components can be designed to a) alter risk preferences
through the pay-to-performance10 sensitivities and b) facilitate the capacity of managers to unwind and thereafter diversify their wealth outside their employer firms. Core, Guay and Larcker (2002) delineate the components of executive compensation. Executives are provided variable compensation and incentives through 1) flow compensation, which is the total of the executive annual salary, bonus, new stock and stock options grants, and other compensation and 2) changes in the value of the executive portfolio of stock and options (exercisable and un-exercisable options). Alternatively, executive compensation can be categorised into cash based components (base salary, bonuses) and stock based components (stock options, long term incentive plans (LTIP), and restricted stock), (Gao and Shrieves, 2002). There has been a proliferation of managerial stock options and stock based compensation, driven by the goal of creating a pay-to-performance sensitivity and aligning shareholder and manager risk preferences. Stock based compensation including stock and stock options represents about 50% of the total compensation received by CEOs from 1996 onwards and the median exposure of CEO wealth to firm stock price tripled between 1980 and 1994 and doubled between 1994 and 2000 (Hall and Liebman, 2000).
2.3.3.1 Pay-to-performance sensitivity and managerial risk incentives
Pay-to-performance sensitivity can be characterised as being either linear or convex depending on the sensitivity of the value of the compensation to movements of either stock price or stock price volatility. A linear function depicts a constant change in value of compensation/managerial wealth for every unit change in stock price. In other words, it reflects a constant slope for the function of executive compensation value and stock price. On the other hand, a convex function depicts an increasing change in value of managerial wealth for every unit increase in the volatility of stock price. In other words, it reflects an increasing slope for the function of executive compensation value and stock price volatility. The linearity and convexity of the managerial wealth distribution function creates a linkage between managerial risk aversion, risk management choices and the directional movement and volatility of a firm’s stock price (Core, Guay, and Larcker, 2002; Holmstrom, 1979). These elements are discussed further below.
2.3.3.2 Convex and linear pay-to- performance sensitivities
Convexity
The value of stock option value has a convex relationship with underlying stock price and volatility. Figure 2.2 below depicts the nature of a convex pay-to-performance function. A convex pay-to-performance function results in managerial wealth increasing, at an increasing
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Pay-to-performance sensitivity can be defined as the variation in executive compensation value resulting from the variation in either firm performance level or volatility. A pay-to-performance alignment has been advocated by various scholars and corporate governance practitioners to ensure that managerial wealth portfolios can mimic the shareholder portfolios and thereafter foster a congruence of risk preferences (Jensen and Meckling, 1976 and Smith and Stulz, 1985).
rate, when the stock volatility or stock price increases. At the same time, it shields the managerial wealth portfolio from any reduction in firm value/stock price. This is because, as visible in the graph in
Figure 2.2
, decreases in firm price have a decreasing impact on managerial wealth. Hence volatility increases the overall expected wealth of managers as upswings in stock price have an increasingly larger impact on firm value while downswings have a decreasing impact on firm value. Compensation contracts with convex characteristics provide greater incentives for managerial risk seeking preference.Linearity
A linear pay-to-performance relationship can result from the granting of stock compensation (LTIP and restricted stock). A linear pay-to-performance function, as shown in Figure 2.3 below, will only lead to an increase in managerial wealth when the stock price increases and it will lead to a corresponding reduction in managerial wealth when the stock price decreases. The incentive effective will depend on the slope or delta (sensitivity of shareholder wealth to stock price) of the linear function. The greater the slope value, the greater will be the wealth fluctuation when stock prices change. Hence an increase in delta will increase managerial risk aversion because volatility of stock price/firm value creates a larger managerial wealth fluctuation. Consistent with these arguments, linearity may result in greater managerial risk aversion (Smith and Stulz, 1985).
Managerial
Wealth ($) Convex Wealth Utility Function
0 50000 100000 150000 200000 250000 300000 350000 400000 450000 500000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Stock price standard deviation
Figure 2.3:Linear pay-to-performance function (Wealth’$’000 and Stock Price-$) Linear wealth utility
0 50 100 150 200 250 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 Stock Price W e a lt h Linear
The impact of risk aversion resulting from the linear pay-to-performance sensitivity can be measured by the slope or delta (sensitivity of managerial wealth to a $ change in stock price). An increase in delta should lead to increased managerial risk aversion.
Empirical evidence
Since stock options introduce convex pay-to- performance sensitivity, the proportion of stock options in managerial wealth/ compensation may be a suitable proxy for the convexity and reduced risk aversion. Indeed, several empirical papers (Gao and Shrieves, 2002 and Barton, 2001), have modelled risk incentives using proportion of stock options. However, theoretical arguments by Carpenter (2000) and Ross (2004) and empirical evidence from Knopf, Nam and Thornton (2002), show that granting more stock or option based compensation does not always result in a consistent alteration in the managerial risk preference (e.g. more stock options will not necessarily result in less risk averse or more risk seeking managers). Carpenter (2000) finds that the observed risk preference depends on the class of utility functions that govern a manager’s behaviour. If a manager has a constant relative risk aversion utility function (CRRA), as the asset value (wealth in the firm) grows or if the evaluation date is far away, the manager will moderate asset risk. Managers are assumed to target a fixed volatility level for their personal portfolio of options and outside wealth. Giving a manager more stock options increases the volatility of his/her personal portfolio. To mitigate the increase in volatility of personal portfolio, the manager will aim to reduce the volatility of the underlying asset portfolio (or firm asset value). Similarly, Ross (2004) questions the conventional wisdom that the presence of stock options automatically alters the risk preference of managers. Ross (2004) develops a theoretical model that examines risk taking behaviour when the fee schedule (executive compensation) for the agent (manager) is a
call option and when the fee schedule is equivalent to a short put option or bond position. He also models the alteration of respective utility functions. Ross’ (2004) principal conclusion is no contract exists, which will make all managers who seek to maximise expected utility to be less risk averse. For example, he asserts that call options and put options have different incentive effects. Put options make individuals less risk averse, while call options do not.
Furthermore, Supanvanij et al (2006) argue that managerial risk incentives and hedging choices can be determined by whether executive options are in-, out- or at- the money. In other words, whether or not, they have a positive intrinsic value due to the exercise price being lower than the trading price of the underlying shares. If options are out-of-the- money (i.e. stock price is much lower than exercise price), then volatility is desirable as it increases the likelihood of managerial wealth increase and mangers become risk seeking and concurrently hedge less. On the other hand when options are at-the- money (i.e. stock price is close to option exercise price) or in-the- money (i.e. stock price is higher than the exercise price), then managers are likely to be anxious about firm performance volatility as it could result in their option portfolio being out-of-the- money. Hence, they become more risk averse and are likely to hedge more or engage in smoothing firm performance.
The line of reasoning, highlighting the variation of risk preferences despite the granting of options to managers, strengthens the argument against simplistically taking proportion of options as proxy for reduced risk. Based on reasoning similar to Knopf (2002), rather than taking proportion of stock options, Guay (1999) proposes the use of vega and delta11 as appropriate measures of managerial risk preferences. These sensitivities can act in opposing directions in shaping managers’ risk preferences. Increased sensitivity to stock price levels (i.e. higher delta) may create risk aversion, while increased sensitivity to volatility (i.e. higher vega) may encourage risk seeking. Recent empirical papers have used vega and delta to measure risk seeking incentives (Supanvanij et al, 2006; Rogers, 2002; Core and Guay 2002; Knopf, Nam and Thornton 2002). Supanvanij et al (2006) and Rogers (2002), find a significant association of the vega and delta measures and level of hedging. A further discussion of the measurement of vega and delta risk incentive is included in the research design in 4.6.1.
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Delta = the sensitivity of the option value with respect to a 1% change in stock price Vega = the sensitivity of the option value with respect to a 1% change in stock volatility
2.3.3.3 Diversification of Managerial wealth
Managers may moderate the impact of compensation based risk incentives if they can
diversify their wealth portfolios. The capacity of managers to diversify their wealth moderates their risk exposure caused by the concentration of their wealth and human capital in their employer firms. Diversification can be achieved through the hedging of personal income or through the granting of cash compensation. These two aspects are explained further below
Managerial personal hedging
Bettis, Bizjak and Lemmon, (2001), show that managers can unwind some of the risk of their undiversified portfolio. Managers can use zero cost collars12 and equity swaps to hedge the risk associated with their personal holdings. The studies show that the mean number of shares hedged is 36% of total holdings and that this can effectively reduce the risk associated with their personal holdings by 25%. Bettis et al (2001) made use of a private database (Primark Data Company, a firm contracted by the SEC to collect information on insider trading) and this database is not accessible for the purposes of this research.
Cash Compensation
The greater the cash compensation that can be invested outside the firm, the more likely it will be that the CEO holds a diversified wealth portfolio and hence the lower her risk aversion. The current period cash compensation may be a suitable proxy for risk aversion as it represents the proportion of compensation demanded by managers, which is not sensitive to stock price volatility (Coles, Daniel and Naveen, 2005).
2.3.3.4 Summary: managerial risk incentives and derivatives use
As discussed above, managerial hedging choices can be driven by the goal of optimising managerial wealth rather than shareholder value. In the above sections, I have reviewed the linkage between executive compensation, managerial risk preferences and risk management choices. The form of compensation can influence risk preferences and it is on this basis that compensation can offset agency costs as it can align manager risk preferences to that of shareholders. This in turn can influence their inclination to use derivatives for risk management purposes. The literature shows that stock options introduce risk seeking tendencies and this can offset the relative risk aversion that arises from managers holding
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A zero cost collar involves the purchase of a put option funded by the proceeds received from the sale of a call option on the stock of the company. An equity swap is an exchange of the returns on the firm’s stock for the cash flows on an asset such as an index fund or risk free security. A zero cost collar option limits the downside and upside of the manager’s holding of the stock (long position) and hence makes the manager less sensitive to volatility. The increase in payoff function value is limited to lower and upper bound exercise price.
relatively undiversified portfolios. On the other hand, stock based compensation (LTIP, shares granted) has a linear pay-to-performance function and this creates or maintains the risk aversion and likelihood of managers using derivatives. For example risk averse managers may engage in full cover hedging in situations where it would be to the interest of shareholders to partially hedge an exposure. The literature also shows that granting cash compensation or zero collar options to managers can offset their risk aversion as these enables them to hold more diversified portfolios.