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|Business transactions and developments often involve
the creation and exercise of options.
Possession of options may reduce risk. Granting options may encourage risk-taking.
|Volatility and Risk. Giving share options to executives encourages reckless management, because the value of options increases with the value and volatility of the underlying asset.|
Volatility and Risk - How Options Encourage Reckless Managementveryard projects > risk > options > volatility and risk
Many commentators have noted the perverse effects of this, and this is often attributed to the asymmetric nature of the holding. Executives holding share options are rewarded for any increase in the underlying share price, but are not (directly) penalized for any decrease. This one-sided motivation becomes a one-way bet for the executives, and so encourages risk-taking. However, since executives might otherwise be excessively cautious, it might not always be a bad thing to encourage them to take risks.
There is a further motivator, which is less often discussed, but whose effects are more perverse. According to option pricing theory, the value of an option increases with the volatility of the underlying asset. (This may be calculated using the Brook-Scholes formula.) This means that executives holding share options are motivated to act in a way that increases share price volatility. But volatility reduces the investment return for long-term shareholders and increases the company's cost of capital. Granting share options therefore directly opposes the interests of executives to the interests of long-term shareholders and the company itself.
Even where options serve their proper function in reducing some aspect
of risk, the phenomenon of risk equalization may simply restore overall
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