Essays on Stock Options, Incentives, and Managerial Action

Executive compensation and managerial behavior have received an increasing amount of attention in the financial economics literature since the mid 1970s. The purpose of this thesis is to extend our understanding of managerial compensation, especially how stock option compensation is linked to the actions undertaken by the management. Furthermore, managerial compensation is continuously and heatedly debated in the media and an emerging consensus from this discussion seems to be that there still exists gaps in our knowledge of optimal contracting. In Finland, the first executive stock options were introduced in the 1980s and throughout the last 15 years it has become increasingly popular for Finnish listed firms to use this type of managerial compensation. The empirical work in the thesis is conducted using data from Finland, in contrast to most previous studies that predominantly use U.S. data. Using Finnish data provides insight of how market conditions affect compensation and managerial action and provides an opportunity to explore what parts of the U.S. evidence can be generalized to other markets. The thesis consists of four essays. The first essay investigates the exercise policy of the executive stock option holders in Finland. In summary, Essay 1 contributes to our understanding of the exercise policies by examining both the determinants of the exercise decision and the markets reaction to the actual exercises. The second essay analyzes the factors driving stock option grants using data for Finnish publicly listed firms. Several agency theory based variables are found to have have explanatory power on the likelihood of a stock option grant. Essay 2 also contributes to our understanding of behavioral factors, such as prior stock return, as determinants of stock option compensation. The third essay investigates the tax and stock option motives for share repurchases and dividend distributions. We document strong support for the tax motive for share repurchases. Furthermore, we also analyze the dividend distribution decision in companies with stock options and find a significant difference between companies with and without dividend protected options. We thus document that the cutting of dividends found in previous U.S. studies can be avoided by dividend protection. In the fourth essay we approach the puzzle of negative skewness in stock returns from an altogether different angle than in previous studies. We suggest that negative skewness in stock returns is generated by management disclosure practices and find proof for this. More specifically, we find that negative skewness in daily returns is induced by returns for days when non-scheduled firm specific news is disclosed.

Essays on Stock Option Compensation and the Role of Incentives and Risk (summary section only)

Managerial pay-for-performance sensitivity has increased rapidly around the world. Early empirical research showed that pay-for-performance sensitivity resulting from stock ownership and stock options appeared to be quite low during the 1970s and early 1980s in the U.S. However, recent empirical research from the U.S. shows an enormous increase in pay-for-performance sensitivity. The global trend has also reached Finland, where stock options have become a major ingredient of executive compensation. The fact that stock options seem to be an appealing form of remuneration from a theoretical point of view combined with the observation that the use of this compensation form has increased significantly during the recent years, implies that research on the dynamics of stock option compensation is highly relevant for the academic community, as well as for practitioners and regulators. The research questions of the thesis are analyzed in four separate essays. The first essay examines whether stock option compensation practices of Finnish firms are consistent with predictions from principal-agent theory. The second essay explores one of the major puzzles in the compensation literature by studying determinants of stock option contract design. In theory, optimal contract design should vary according to firm characteristics. However, in the U.S., variation in contract design seems to be surprisingly low, a phenomenon generally attributed to tax and accounting considerations. In Finland, however, firms are not subject to stringent contracting restrictions, and the variation in contract design tends, in fact, to be quite substantial. The third essay studies the impact of price- and risk incentives arising from stock option compensation on firm investment. In addition, the essay explores one of the most debated questions in the literature, in particular, the relation between incentives and firm performance. Finally, several strands of literature in both economics and corporate finance hypothesize that economic uncertainty is related to corporate decision-making. Previous research has shown that risk tends to slow down firm investment. In the fourth essay, it is hypothesized that firm risk slows down growth from a more universal perspective. Consistent with this view, it is shown that risk not only tends to slow down firm investment, but also employment growth. Moreover, the essay explores whether the nature of firms’ compensation policies, in particular, whether firms make use of stock option compensation, affects the relation between risk and firm growth. In summary, the four essays contribute to the current understanding of stock options as a form of equity incentives, and how incentives and risk affect corporate decision-making. By this, the thesis promotes the knowledge related to the modern theory of the firm.

What Determines Stock Option Contract Design?

This paper analyzes factors driving the design of stock option plans for Finnish firms. We examine determinants of the scope of plans, exercise price, target group, and dividend protection. The scope is found to be negatively related to Tobin’s Q and positively related to proxies for monitoring costs. The scope is also greater in broad-based plans, and in plans with dividend protection. Prior stock return is found to be negatively related to the size of the premium (out-of-the-moneyness), whereas dividend protection increases the premium. The results also suggest that investment intensity, cash flow, and monitoring costs are associated with the likelihood of granting premium (out-of-the-money) stock options. Furthermore, the likelihood of granting broad-based plans is increasing in institutional ownership and cash flow constraints, and decreasing in firm size. Broad-based plans are also more likely among firms in growth industries. We find support that the likelihood of dividend protection is decreasing in foreign ownership. In addition, firms paying zero-dividends are less likely to include dividend protection, whereas higher unsystematic risk is associated with a greater likelihood of including dividend protection.

Pitch discrimination in optimal and suboptimal acoustic environments: electroencephalographic, magnetoencephalographic, and behavioral evidence

Pitch discrimination is a fundamental property of the human auditory system. Our understanding of pitch-discrimination mechanisms is important from both theoretical and clinical perspectives. The discrimination of spectrally complex sounds is crucial in the processing of music and speech. Current methods of cognitive neuroscience can track the brain processes underlying sound processing either with precise temporal (EEG and MEG) or spatial resolution (PET and fMRI). A combination of different techniques is therefore required in contemporary auditory research. One of the problems in comparing the EEG/MEG and fMRI methods, however, is the fMRI acoustic noise. In the present thesis, EEG and MEG in combination with behavioral techniques were used, first, to define the ERP correlates of automatic pitch discrimination across a wide frequency range in adults and neonates and, second, they were used to determine the effect of recorded acoustic fMRI noise on those adult ERP and ERF correlates during passive and active pitch discrimination. Pure tones and complex 3-harmonic sounds served as stimuli in the oddball and matching-to-sample paradigms. The results suggest that pitch discrimination in adults, as reflected by MMN latency, is most accurate in the 1000-2000 Hz frequency range, and that pitch discrimination is facilitated further by adding harmonics to the fundamental frequency. Newborn infants are able to discriminate a 20% frequency change in the 250-4000 Hz frequency range, whereas the discrimination of a 5% frequency change was unconfirmed. Furthermore, the effect of the fMRI gradient noise on the automatic processing of pitch change was more prominent for tones with frequencies exceeding 500 Hz, overlapping with the spectral maximum of the noise. When the fundamental frequency of the tones was lower than the spectral maximum of the noise, fMRI noise had no effect on MMN and P3a, whereas the noise delayed and suppressed N1 and exogenous N2. Noise also suppressed the N1 amplitude in a matching-to-sample working memory task. However, the task-related difference observed in the N1 component, suggesting a functional dissociation between the processing of spatial and non-spatial auditory information, was partially preserved in the noise condition. Noise hampered feature coding mechanisms more than it hampered the mechanisms of change detection, involuntary attention, and the segregation of the spatial and non-spatial domains of working-memory. The data presented in the thesis can be used to develop clinical ERP-based frequency-discrimination protocols and combined EEG and fMRI experimental paradigms.

Essays on socially optimal phosphorus policies in crop production

Phosphorus is a nutrient needed in crop production. While boosting crop yields it may also accelerate eutrophication in the surface waters receiving the phosphorus runoff. The privately optimal level of phosphorus use is determined by the input and output prices, and the crop response to phosphorus. Socially optimal use also takes into account the impact of phosphorus runoff on water quality. Increased eutrophication decreases the economic value of surface waters by Deteriorating fish stocks, curtailing the potential for recreational activities and by increasing the probabilities of mass algae blooms. In this dissertation, the optimal use of phosphorus is modelled as a dynamic optimization problem. The potentially plant available phosphorus accumulated in soil is treated as a dynamic state variable, the control variable being the annual phosphorus fertilization. For crop response to phosphorus, the state variable is more important than the annual fertilization. The level of this state variable is also a key determinant of the runoff of dissolved, reactive phosphorus. Also the loss of particulate phosphorus due to erosion is considered in the thesis, as well as its mitigation by constructing vegetative buffers. The dynamic model is applied for crop production on clay soils. At the steady state, the analysis focuses on the effects of prices, damage parameterization, discount rate and soil phosphorus carryover capacity on optimal steady state phosphorus use. The economic instruments needed to sustain the social optimum are also analyzed. According to the results the economic incentives should be conditioned on soil phosphorus values directly, rather than on annual phosphorus applications. The results also emphasize the substantial effects the differences in varying discount rates of the farmer and the social planner have on optimal instruments. The thesis analyzes the optimal soil phosphorus paths from its alternative initial levels. It also examines how erosion susceptibility of a parcel affects these optimal paths. The results underline the significance of the prevailing soil phosphorus status on optimal fertilization levels. With very high initial soil phosphorus levels, both the privately and socially optimal phosphorus application levels are close to zero as the state variable is driven towards its steady state. The soil phosphorus processes are slow. Therefore, depleting high phosphorus soils may take decades. The thesis also presents a methodologically interesting phenomenon in problems of maximizing the flow of discounted payoffs. When both the benefits and damages are related to the same state variable, the steady state solution may have an interesting property, under very general conditions: The tail of the payoffs of the privately optimal path as well as the steady state may provide a higher social welfare than the respective tail of the socially optimal path. The result is formalized and an applied to the created framework of optimal phosphorus use.

Computationally Efficient Methods for MDL-Optimal Density Estimation and Data Clustering

The Minimum Description Length (MDL) principle is a general, well-founded theoretical formalization of statistical modeling. The most important notion of MDL is the stochastic complexity, which can be interpreted as the shortest description length of a given sample of data relative to a model class. The exact definition of the stochastic complexity has gone through several evolutionary steps. The latest instantation is based on the so-called Normalized Maximum Likelihood (NML) distribution which has been shown to possess several important theoretical properties. However, the applications of this modern version of the MDL have been quite rare because of computational complexity problems, i.e., for discrete data, the definition of NML involves an exponential sum, and in the case of continuous data, a multi-dimensional integral usually infeasible to evaluate or even approximate accurately. In this doctoral dissertation, we present mathematical techniques for computing NML efficiently for some model families involving discrete data. We also show how these techniques can be used to apply MDL in two practical applications: histogram density estimation and clustering of multi-dimensional data.

Causes and consequences of variation in nestling immune function

Defence against pathogens is a vital need of all living organisms that has led to the evolution of complex immune mechanisms. However, although immunocompetence the ability to resist pathogens and control infection has in recent decades become a focus for research in evolutionary ecology, the variation in immune function observed in natural populations is relatively little understood. This thesis examines sources of this variation (environmental, genetic and maternal effects) during the nestling stage and its fitness consequences in wild populations of passerines: the blue tit (Cyanistes caeruleus) and the collared flycatcher (Ficedula albicollis). A developing organism may face a dilemma as to whether to allocate limited resources to growth or to immune defences. The optimal level of investment in immunity is shaped inherently by specific requirements of the environment. If the probability of contracting infection is low, maintaining high growth rates even at the expense of immune function may be advantageous for nestlings, as body mass is usually a good predictor of post-fledging survival. In experiments with blue tits and haematophagous hen fleas (Ceratophyllus gallinae) using two methods, methionine supplementation (to manipulate nestlings resource allocation to cellular immune function) and food supplementation (to increase resource availability), I confirmed that there is a trade-off between growth and immunity and that the abundance of ectoparasites is an environmental factor affecting allocation of resources to immune function. A cross-fostering experiment also revealed that environmental heterogeneity in terms of abundance of ectoparasites may contribute to maintaining additive genetic variation in immunity and other traits. Animal model analysis of extensive data collected from the population of collared flycatchers on Gotland (Sweden) allowed examination of the narrow-sense heritability of PHA-response the most commonly used index of cellular immunocompetence in avian studies. PHA-response is not heritable in this population, but is subject to a non-heritable origin (presumably maternal) effect. However, experimental manipulation of yolk androgen levels indicates that the mechanism of the maternal effect in PHA-response is not in ovo deposition of androgens. The relationship between PHA-response and recruitment was studied for over 1300 collared flycatcher nestlings. Multivariate selection analysis shows that it is body mass, not PHA-response, that is under direct selection. PHA-response appears to be related to recruitment because of its positive relationship with body mass. These results imply that either PHA-response fails to capture the immune mechanisms that are relevant for defence against pathogens encountered by fledglings or that the selection pressure from parasites is not as strong as commonly assumed.

Angel Investing in Finland: An Analysis Based on Agency Theory and the Incomplete Contracting Theory

Wealthy individuals - business angels who invest a share of their net worth in entrepreneurial ventures - form an essential part of an informal venture capital market that can secure funding for entrepreneurial ventures. In Finland, business angels represent an untapped pool of capital that can contribute to fostering entrepreneurial development. In addition, business angels can bridge knowledge gaps in new business ventures by means of making their human capital available. This study has two objectives. The first is to gain an understanding of the characteristics and investment behaviour of Finnish business angels. The strongest focus here is on the due diligence procedures and their involvement post investment. The second objective is to assess whether agency theory and the incomplete contacting theory are useful theoretical lenses in the arena of business angels. To achieve the second objective, this study investigates i) how risk is mitigated in the investment process, ii) how uncertainty influences the comprehensiveness of due diligence as well as iii) how control is allocated post investment. Research hypotheses are derived from assumptions underlying agency theory and the incomplete contacting theory. The data for this study comprise interviews with 53 business angels. In terms of sample size this is the largest on Finnish business angels. The research hypotheses in this study are tested using regression analysis. This study suggests that the Finnish informal venture capital market appears to be comprised of a limited number of business angels whose style of investing much resembles their formal counterparts’. Much focus is placed on managing risks prior to making the investment by strong selectiveness and by a relatively comprehensive due diligence. The involvement is rarely on a day-to-day basis and many business angels seem to see board membership as a more suitable alternative than involvement in the operations of an entrepreneurial venture. The uncertainty involved does not seem to drive an increase in due diligence. On the contrary, it would appear that due diligence is more rigorous in safer later stage investments and when the business angels have considerable previous experience as investors. Finnish business angels’ involvement post investment is best explained by their degree of ownership in the entrepreneurial venture. It seems that when investors feel they are sufficiently rewarded, in terms of an adequate equity stake, they are willing to involve themselves actively in their investments. The lack of support for a relationship between increased uncertainty and the comprehensiveness of due diligence may partly be explained by an increasing trend towards portfolio diversification. This is triggered by a taxation system that favours investments through investment companies rather than direct investments. Many business angels appear to have substituted a specialization strategy that builds on reducing uncertainty for a diversification strategy that builds on reducing firm specific (idiosyncratic) risk by holding shares in ventures whose returns are not expected to exhibit a strong positive correlation.

Optimal Risk Adoption: A Real Options Approach

This study develops a real options approach for analyzing the optimal risk adoption policy in an environment where the adoption means a switch from one stochastic flow representation into another. We establish that increased volatility needs not decelerate investment, as predicted by the standard literature on real options, once the underlying volatility of the state is made endogenous. We prove that for a decision maker with a convex (concave) objective function, increased post-adoption volatility increases (decreases) the expected cumulative present value of the post-adoption profit flow, which consequently decreases (increases) the option value of waiting and, therefore, accelerates (decelerates) current investment.

Bank Run Risk and Optimal Reserves

We characterize the optimal reserves, and the generated probability of a bank run, as a function of the penalty imposed by the central bank, the probability of depositors’ liquidity needs, and the return on outside investment opportunities.

Optimal management of conflicting species: Grey seal (Halichoerus grypus) and Atlantic salmon (Salmo salar) in the Baltic Sea

The objective of this thesis is to examine the economic effects in the conflict between grey seal population and the salmon fishery in the Baltic Sea. We will formulate a bioeconomic model which provides new insights on the optimal management of Atlantic salmon with respect to the effects brought about by the grey seal population. As the catch losses caused by seals have an effect on salmon fishery in Baltic, we will study how seal population affects the present value of the salmon fishery. The study considers the Finnish coastal trap net fishery. The bioeconomic model considers a scenario of sole salmon fishery and a scenario of salmon fishery affected by the grey seal population. On the basis of these scenarios, a seal compensation scheme is introduced. We can observe a significant economic seal-induced effect on the salmon fishery. The results suggest that the present seal compensation scheme emploid by the Finnish government is suboptimal. This thesis is part of the TARMO –project, in which the conflict between grey seal population and salmon fishery is studied using the methods of environmental economics.

Stock Option Compensation in Finland: An Analysis of Economic Determinants, Contracting Frequency, and Design

This paper addresses several questions in the compensation literature by examining stock option compensation practices of Finnish firms. First, the results indicate that principal-agent theory succeeds quite well in predicting the use of stock options. Proxies for monitoring costs, growth opportunities, ownership structure, and risk are found to determine the use of incentives consistent with theory. Furthermore, the paper examines whether determinants of stock options targeted to top management differ from determinants of broad-based stock option plans. Some evidence is found that factors driving these two types of incentives differ. Second, the results reveal that systematic risk significantly increases the likelihood that firms adopt stock option plans, whereas total firm risk and unsystematic risk do not seem to affect this decision. Third, the results show that growth opportunities are related to time-dimensional contracting frequency, consistent with the argument that incentive levels deviate more rapidly from optimum in firms with high growth opportunities. Finally, the results suggest that vesting schedules are decreasing in financial leverage, and that contract maturity is decreasing in firm focus. In addition, both vesting schedules and contract maturity tend to be longer in firms involving state ownership.