Executive stock options are expected to reduce the agency problem of underinvestment because the convex payoff structure provides executives with incentives to align the decisions of executives with the desire of its shareholders. However, the risk-taking incentive effects of ESOs on managerial innovative activities remain a debated issue in prior studies. Therefore, we examine the incentive effects of ESOs on managerial innovative activities with the inclusion of the endogeneity between ESO risk incentives and innovation. We find that, first, the incentive effects of ESOs with the exclusion of
endogeneity are significant positively associated with managerial innovative activities. This is consistent with Rajgopal and Shevlin (2002) that executives appear to undertake more risky innovative activities with the incentive effects of ESOs. Second, taking the endogeneity of ESO risk incentives into consideration, we also find a significant positive relation between the incentive effects of ESOs and managerial innovative activities. This
finding implies that if the exogenous determinants of ESO risk incentives changed so as to induce an increase of ESO risk incentives, then we would expect an increase in the
subsequent managerial innovative activities, holding other exogenous determinants of managerial innovative activities constant. Third, the risk-taking incentive effects of ESOs
in old economy are not as significant as those in new economy, which can be used to explain that the incentive effects of ESOs can not encourage executives to undertake
innovative activities.

1.Abernathy, W.J. and K.B. Clark, INNOVATION - MAPPING THE
WINDS OF CREATIVE DESTRUCTION. Research Policy, 14(1):
p.3-22, 1985.
2.Acs, Z.J. and D.B. Audretsch, INNOVATION IN LARGE AND
SMALL FIRMS -AN EMPIRICAL-ANALYSIS. American Economic
Review, 78(4): p. 678-690, 1988.
3.Aggarwal, R.K. and A.A. Samwick, The other side of the
trade-off: The impact of risk on executive compensation.
Journal of Political Economy, 107(1): p. 65-105, 1999.
4.Aghion, P. and J. Tirole, THE MANAGEMENT OF INNOVATION.
Quarterly Journal of Economics, 109(4): p. 1185-1209,
1994.
5.Agrawal, A. and G.N. Mandelker, MANAGERIAL INCENTIVES
AND CORPORATE-INVESTMENT AND FINANCING DECISIONS.
Journal of Finance, 42(4): p. 823-837, 1987.
6.Anderson, M.C., R.D. Banker, and S. Ravindran, Executive
compensation in the information technology industry.
Management Science, 46(4): p. 530-547, 2000.
7.Arrow, K.J., CLASSIFICATORY NOTES ON PRODUCTION AND
TRANSMISSION OF TECHNOLOGICAL KNOWLEDGE. American
Economic Review, 59(2): p. 29-35, 1969.
8.Balkin, D.B., G.D. Markman, and L.R. Gomez-Mejia, Is CEO
pay in high-technology firms related to innovation?
Academy of Management Journal, 43(6): p. 1118-1129,
2000.
9.Becker, B., Wealth and executive compensation. Journal
of Finance, 61(1): p. 379-397, 2006.
10.Benner, M.J., Process management and technological
innovation: A longitudinal study of the photography and
paint industries. Administrative Science Quarterly, 47
(4): p. 676-706, 2002.
11.Benner, M.J. and M.L. Tushman, Exploitation,
exploration, and process management: The productivity
dilemma revisited. Academy of Management Review, 28(2):
p. 238-256, 2003.
12.Bennis, W. and B. Nanus, Leaders: Strategies for Taking
Charge. Harper Business New York. 1997.
13.Bitler, M.P., T.J. Moskowitz, and A. Vissing-Jorgensen,
Testing agency theory with entrepreneur effort and
wealth. Journal of Finance, 60(2): p. 539-576, 2005.
14.Bolton, P. and C. Harris, Strategic experimentation.
Econometrica, 67(2): p. 349-374, 1999.
15.Bryan, S., L. Hwang, and S. Lilien, CEO stock-based
compensation: An empirical analysis of incentive-
intensity, relative mix, and economic determinants.
Journal of Business, 73(4): p. 661-693, 2000.
16.Carpenter, J.N., Does option compensation increase
managerial risk appetite? Journal of Finance, 55(5): p.
2311-2331, 2000.
17.Carpenter, M.A., T.G. Pollock, and M.M. Leary, Testing
a model of reasoned risk-taking: Governance, the
experience of principals and agents, and global
strategy in high-technology IPO firms. Strategic
Management Journal, 24(9): p. 803-820, 2003.
18.Carpenter, M.A. and J.B. Wade, Microlevel opportunity
structures as determinants of non-CEO executive pay.
Academy of Management Journal, 45(6): p. 1085-1103,
2002.
19.Chen, C.R., T.L. Steiner, and A.M. Whyte, Does stock
option-based executive compensation induce risk-taking?
An analysis of the banking industry. Journal of Banking
& Finance, 30(3): p. 915-945, 2006.
20.Choe, C., Leverage, volatility and executive stock
options. Journal of Corporate Finance, 9(5): p. 591-
609, 2003.
21.Core, J. and W. Guay, Estimating the value of employee
stock option portfolios and their sensitivities to
price and volatility. Journal of Accounting Research, 40
(3): p. 613-630, 2002.
22.Coles, J. L., N. D. Daniel and L. Naveen, Executive
Compensation and Managerial Risk-Taking. Working Paper,
2003.
23.Copeland, T. and J. Weston, Financial Theory and
Corporate Policy. Addison Wesley Publishing Co.,
Reading, MA, 1988.
24.Damanpour, F., ORGANIZATIONAL INNOVATION - A
METAANALYSIS OF EFFECTS OF DETERMINANTS AND MODERATORS.
Academy of Management Journal, 34(3): p. 555-590, 1991.
25.Danneels, E., The dynamics of product innovation and
firm competences. Strategic Management Journal, 23(12):
p. 1095-1121, 2002.
26.Dechow, P.M., A.P. Hutton, and R.G. Sloan, Economic
consequences of accounting for stock-based
compensation. Journal of Accounting Research, 34:
p. 1-20, 1996.
27.Dee, C.C., A. Lulseged, and T.S. Nowlin, Executive
compensation and risk: The case of internet firms.
Journal of Corporate Finance, 12(1): p. 80-96, 2005.
28.Dewatripont, M. and E. Maskin, Contractual
contingencies and renegotiation. Rand Journal of
Economics, 26(4): p. 704-719, 1995.
29.Dow, J. and C.C. Raposo, CEO compensation, change, and
corporate strategy. Journal of Finance, 60(6): p. 2701-
2727, 2005.
30.Eisenhardt, K.M. and J.A. Martin, Dynamic capabilities:
What are they? Strategic Management Journal, 21(10-11):
p. 1105-1121, 2000.
31.Feldman, L.P., The role of salary and incentives in the
new product function. Journal of Product Innovation
Management, 13(3): p. 216-228, 1996.
32.Freel, M.S., Patterns of innovation and skills in small
firms. Technovation, 25(2): p. 123-134, 2005.
33.Garen, J.E., EXECUTIVE-COMPENSATION AND PRINCIPAL-AGENT
THEORY. Journal of Political Economy, 102(6): p. 1175-
1199, 1994.
34.Gaver, J.J. and K.M. Gaver, ADDITIONAL EVIDENCE ON THE
ASSOCIATION BETWEEN THE INVESTMENT OPPORTUNITY SET AND
CORPORATE FINANCING, DIVIDEND, AND COMPENSATION
POLICIES. Journal of Accounting & Economics, 16(1-3):
p. 125-160, 1993.
35.Glucksberg, S., INFLUENCE OF STRENGTH OF DRIVE ON
FUNCTIONAL FIXEDNESS AND PERCEPTUAL RECOGNITION.
Journal of Experimental Psychology, 63(1): p. 36, 1962.
36.Gray, S.R. and A.A. Cannella, The role of risk in
executive compensation. Journal of Management, 23(4):
p. 517-540, 1997.
37.Guay, W.R., The sensitivity of CEO wealth to equity
risk: an analysis of the magnitude and determinants.
Journal of Financial Economics, 53(1): p. 43-71, 1999.
38.Hagedoorn, J. and J. Schakenraad, THE EFFECT OF
STRATEGIC TECHNOLOGY ALLIANCES ON COMPANY PERFORMANCE.
Strategic Management Journal, 15(4): p. 291-309, 1994.
39.Hall, B.J. and K.J. Murphy, Stock options for
undiversified executives. Journal of Accounting &
Economics, 33(1): p. 3-42, 2002.
40.Henderson, V., Stock Based Compensation: Firm-specific
risk, Efficiency and Incentives. Working Paper. 2002.
41.Hanlon, M., S. Rajgopal, and T. Shevlin, Are executive
stock options associated with future earnings? Journal
of Accounting & Economics, 36(1-3): p. 3-43, 2003.
42.Hansen, G.S. and C.W.L. Hill, ARE INSTITUTIONAL
INVESTORS MYOPIC - A TIME-SERIES STUDY OF 4 TECHNOLOGY-
DRIVEN INDUSTRIES. Strategic Management Journal, 12(1):
p. 1-16, 1991.
43.Harris, M. and A. Raviv, THE THEORY OF CAPITAL
STRUCTURE. Journal of Finance, 46(1): p. 297-355, 1991.
44.Haugen, R.A. and L.W. Senbet, RESOLVING THE AGENCY
PROBLEMS OF EXTERNAL CAPITAL THROUGH OPTIONS. Journal
of Finance, 36(3): p. 629-647, 1981.
45.Hemmer, T., O. Kim, and R.E. Verrecchia, Introducing
convexity into optimal compensation contracts. Journal
of Accounting & Economics, 28(3): p. 307-327, 1999.
46.Henderson, V., The impact of the market portfolio on
the valuation, incentives and optimality of executive
stock options. Quantitative Finance, 5(1): p. 35-47,
2005.
47.Hill, C.W.L. and F.T. Rothaermel, The performance of
incumbent firms in the face of radical technological
innovation. Academy of Management Review, 28(2): p. 257-
274, 2003.
48.Hill, C.W.L. and S.A. Snell, EXTERNAL CONTROL,
CORPORATE STRATEGY, AND FIRM PERFORMANCE IN RESEARCH-
INTENSIVE INDUSTRIES. Strategic Management Journal, 9
(6): p. 577-590, 1988.
49.Hirshleifer, D. and R. Suh, Risk, managerial effort,
and project choice. Journal of Financial
Intermediation, 2, 308-345, 1992.
50.Holmstrom, B., MORAL HAZARD AND OBSERVABILITY. Bell
Journal of Economics, 10(1): p. 74-91, 1979.
51.Holmstrom, B., AGENCY COSTS AND INNOVATION. Journal of
Economic Behavior & Organization, 12(3): p. 305-327,
1989.
52.Holmstrom, B. and P. Milgrom, MULTITASK PRINCIPAL AGENT
ANALYSES-INCENTIVE CONTRACTS, ASSET OWNERSHIP, AND JOB
DESIGN. Journal of Law Economics & Organization, 7: p.
24-52, 1991.
53.Holthausen, R.W., D.F. Larcker, and R.G. Sloan,
BUSINESS UNIT INNOVATION AND THE STRUCTURE OF EXECUTIVE-
COMPENSATION. Journal of Accounting & Economics,
19(2-3): p. 279-313, 1995.
54.Hoskisson, R.E., M.A. Hitt, and C.W.L. Hill, MANAGERIAL
INCENTIVES AND INVESTMENT IN RESEARCH-AND-DEVELOPMENT
IN LARGE MULTIPRODUCT FIRMS. Organization Science, 4
(2): p. 325-341, 1993.
55.Ittner, C.D., R.A. Lambert, and D.F. Larcker, The
structure and performance consequences of equity grants
to employees of new economy firms. Journal of
Accounting & Economics, 34(1-3): p. 89-127, 2003.
56.Jansen, J.J.P., F.A.J. Van den Bosch, and H.W.Volberda,
Exploratory innovation, exploitative innovation, and
performance: Effects of organizational antecedents and
environmental moderators. Management Science, 52(11):
p.1661-1674, 2006.
57.Jensen, M.C. and W.H. Meckling, THEORY OF FIRM-
MANAGERIAL BEHAVIOR, AGENCY COSTS AND OWNERSHIP
STRUCTURE. Journal of Financial Economics, 3(4):
p. 305-360, 1976.
58.Jovanovic, B. and Y. Nyarko, Learning by doing and the
choice of technology. Econometrica, 64(6): p. 1299-
1310, 1996.
59.Ju, N., H. Leland and L. W. Sebnet, Options, Options
Repricing and Severance Packages in Managerial
Compensation: Their Effects on Corporate. Working
Paper. 2002.
60.Kamien , M. and N. Schwartz, Market Structure and
Innovation. Cambridge: Cambridge University Press.
1982.
61.Kimberly, J.R. and M.J. Evanisko, ORGANIZATIONAL
INNOVATION - THE INFLUENCE OF INDIVIDUAL,
ORGANIZATIONAL, AND CONTEXTUAL FACTORS ON HOSPITAL
ADOPTION OF TECHNOLOGICAL AND ADMINISTRATIVE
INNOVATIONS. Academy of Management Journal, 24(4): p.
689-713, 1981.
62.Kochhar, R. and P. David, Institutional investors and
firm innovation: A test of competing hypotheses.
Strategic Management Journal, 17(1): p. 73-84, 1996.
63.Lambert, R.A., D.F. Larcker, and R.E. Verrecchia,
PORTFOLIO CONSIDERATIONS IN VALUING EXECUTIVE-
COMPENSATION. Journal of Accounting Research, 29(1):
p. 129-149, 1991.
64.Lazear, E.P., Performance pay and productivity.
American Economic Review, 90(5): p. 1346-1361, 2000.
65.Leland, H.E., Agency costs, risk management, and
capital structure. Journal of Finance, 53(4): p. 1213-
1243, 1998.
66.Levinthal, D.A. and J.G. March, THE MYOPIA OF LEARNING.
Strategic Management Journal, 14: p. 95-112, 1993.
67.Lewin, A.Y., C.P. Long, and T.N. Carroll, The
coevolution of new organizational forms. Organization
Science, 10(5): p. 535-550, 1999.
68.Lin, B.W. and J.S. Chen, Corporate technology
portfolios and R&D performance measures: a study of
technology intensive firms. R & D Management, 35(2): p.
157-170, 2005.
69.Love, J.H. and S. Roper, The determinants of
innovation: R & D, technology transfer and networking
effects. Review of Industrial Organization, 15(1): p.
43-64, 1999.
70.Makri, M., P.J. Lane, and L.R. Gomez-Mejia, CEO
incentives, innovation, and performance in technology-
intensive firms: A reconciliation of outcome and
behavior-based incentive schemes. Strategic Management
Journal, 27(11): p. 1057-1080, 2006.
71.Manso G., Motivating Innovation. Working Paper. 2006.
72.March J. G., Exploration and Exploitation in
Organization Learning. Organization Science, Vol. 2,
No. 1, p. 71-87, 1991.
73.McGrath, R.G., Exploratory learning, innovative
capacity, and managerial oversight. Academy of
Management Journal, 44(1): p. 118-131, 2001.
74.Merton, R.C., THEORY OF RATIONAL OPTION PRICING. Bell
Journal of Economics, 4(1): p. 141-183, 1973.
75.Milgrom, P. and J. Roberts, Economics, Organizations
and Management. Prentice Hall New Jersey. 1992.
76.Milkovich G. T., B. Gerhart and J. Hannon, The effects
of research and development intensity on managerial
compensation in large organizations. Journal of High
Technology Management Research, Vol. 2, p. 133-145,
1991.
77.Murphy, K.J., Stock-based pay in new economy firms.
Journal of Accounting & Economics, 34(1-3): p. 129-147,
2003.
78.Nohria, N. and C. Garciapont, GLOBAL STRATEGIC LINKAGES
AND INDUSTRY STRUCTURE. Strategic Management Journal,
12: p. 105-124, 1991.
79.Porter, M. E., The Competitive Advantage of Nations,
Free Press, New York. 1990.
80.Quinn, D. P. and P. Rivoli, The Effects of American-
and Japanese- Style Employment and Compensation
Practices on Innovation. Organization Science, Vol. 2,
No. 4, p. 323-341, 1991.
81.Rajgopal, S. and T. Shevlin, Empirical evidence on the
relation between stock option compensation and risk
taking. Journal of Accounting & Economics, 33(2): p.
145-171, 2002.
82.Roberts, P.W., Product innovation, product-market
competition and persistent profitability in the US
pharmaceutical industry. Strategic Management Journal,
20(7): p. 655-670, 1999.
83.Romer, P.M., INCREASING RETURNS AND LONG-RUN GROWTH.
Journal of Political Economy, 94(5): p. 1002-1037, 1986.
84.Rosner, M.M., ECONOMIC DETERMINANTS OF ORGANIZATIONAL
INNOVATION. Administrative Science Quarterly, 12(4): p.
614-625, 1968.
85.Ross, S.A., Compensation, incentives, and the duality
of risk aversion and riskiness. Journal of Finance, 59
(1): p. 207-225, 2004.
86.Rudis, E. V., CEO Challenge: Perspectives and Analysis.
The Conference Board, Report 1353, 2004.
87.Schumpeter, J., The Theory of Economic Development.
Harvard University Press Cambridge, MA. 1934.
88.Smith, C.W. and R.M. Stulz, THE DETERMINANTS OF FIRMS
HEDGING POLICIES. Journal of Financial and Quantitative
Analysis, 20(4): p. 391-405, 1985.
89.Smith, C.W. and R.L. Watts, THE INVESTMENT OPPORTUNITY
SET AND CORPORATE FINANCING, DIVIDEND, AND COMPENSATION
POLICIES. Journal of Financial Economics, 32(3): p. 263-
292, 1992.
90.Stuart, T.E., Interorganizational alliances and the
performance of firms: A study of growth and innovation
rates in a high-technology industry. Strategic
Management Journal, 21(8): p. 791-811, 2000.
91.Vonthadden, E.L., LONG TERM CONTRACTS, SHORT-TERM
INVESTMENT AND MONITORING. Review of Economic Studies,
62(4): p. 557-575, 1995.
92.Wan, D., C.H. Ong, and F. Lee, Determinants of firm
innovation in Singapore. Technovation, 25(3): p. 261-
268, 2005.
93.Xue Y, Make or Buy New Technology – a CEO Compensation
Contract’s Role in a Firm’s Route to Innovation.
Working Paper. 2003.
94.Yermack, D., DO CORPORATIONS AWARD CEO STOCK-OPTIONS
EFFECTIVELY. Journal of Financial Economics, 39(2-3):
p. 237-269, 1995.
95.Zahra, S.A., Governance, ownership, and corporate
entrepreneurship: The moderating impact of industry
technological opportunities. Academy of Management
Journal, 39(6): p. 1713-1735, 1996.
96.Zenger T. R. and S. G. Lazzarini, Compensating for
Innovation: Do Small Firms Offer High-powered
Incentives That Lure Talent and Motivate Effort?.
Managerial and Decision Economics, Vol. 25, p. 329-345,
2004.