Journal Pre-proof

Idiosyncratic Risk, Risk-Taking Incentives and the Relation Between

Managerial Ownership and Firm Value

Chris Florackis , Angelos Kanas , Alexandros Kostakis ,

Sushil Sainani

PII: S0377-2217(19)30938-5
DOI: https://doi.org/10.1016/j.ejor.2019.11.027
Reference: EOR 16163

To appear in: European Journal of Operational Research

Received date: 11 February 2018

Accepted date: 14 November 2019

Please cite this article as: Chris Florackis , Angelos Kanas , Alexandros Kostakis ,
Sushil Sainani , Idiosyncratic Risk, Risk-Taking Incentives and the Relation Between Man-
agerial Ownership and Firm Value, European Journal of Operational Research (2019), doi:
https://doi.org/10.1016/j.ejor.2019.11.027

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Highlights
 Managerial ownership affects performance in a positive way only for low-risk firms
 Risk-substitution offsets the alignment effect of managerial ownership
 High-risk firms exhibit more conservative investment and financing policies
 Risk-substitution problems are mitigated when pay packages include stock options
 Semi-parametric methods capture nonlinearity more precisely

1
 Idiosyncratic Risk, Risk-Taking Incentives and the Relation Between
Managerial Ownership and Firm Value

Chris Florackisa, Angelos Kanasb, Alexandros Kostakisc and Sushil Sainanid

Abstract

In addition to its well-documented alignment effect, managerial ownership also has value-
destroying effects by shifting risk to managers and encouraging risk-substitution; that is, managers
with relatively unhedged personal portfolios tend to pass up profitable projects with high
idiosyncratic (firm-specific) risk in favor of less-profitable projects that have greater aggregate
(market) risk. Using parametric and semi-parametric estimation methods, we examine how
managerial ownership influences firm value in light of the trade-off between the alignment and the
risk-substitution effects. We find that risk-substitution offsets the alignment effect of managerial
ownership in firms that are exposed to severe risk-substitution problems, leading to a weak (or
non-existent) association between managerial ownership and firm value. We identify a plausible
channel for these effects by showing that firms exposed to risk-substitution exhibit more
“conservative” investment and financing policies. We also show that the risk-substitution problem
is partially mitigated by the inclusion of stock options in managerial compensation packages.
Finally, our findings suggest that semi-parametric methods may prove useful for future studies
aiming at capturing nonlinear features in the data.

JEL classification: G3; G32.

Keywords: Finance; Idiosyncratic Risk; Risk-substitution; Managerial Ownership; Semi-parametric
estimation.

1. Introduction

a
Corresponding Author. Department of Accounting and Finance, Management School, University of Liverpool,
United Kingdom. Tel.: + 44 (0) 151 795 3807. Fax: +44 (0) 151 7953000, E-mail: c.florackis@liv.ac.uk
b
Department of Economics, University of Piraeus, Greece, Tel: +30210 4142295, E-mail: akanas@unipi.gr
c
Department of Accounting and Finance, Management School, University of Liverpool, United Kingdom. Tel.:
+ 44 (0) 151 795 3820, E-mail: a.kostakis@liv.ac.uk
d
Department of Accounting and Finance, Management School, University of Liverpool, United Kingdom. Tel.:
+ 44 (0) 151 794 9942, E-mail: s.sainani@liv.ac.uk
2
Agency theory predicts that modern corporations are subject to severe agency problems, whereby
managers may expropriate wealth from shareholders by taking actions such as insufficient effort,
extravagant investment, entrenchment strategies and self-dealing.1 Managerial ownership serves as
a potential mechanism for aligning the interests of managers and shareholders (Jensen and
Meckling, 1976; Shleifer and Vishny, 1997). Despite its well-documented alignment effect,2
however, managerial ownership also increases managers’ exposure to idiosyncratic (firm-specific)
risk, rendering their investment portfolios under-diversified, contrary to the fundamental principle
of modern portfolio theory and practice.
Risk-averse and under-diversified managers can potentially hedge their portfolio positions by
selling short their own firm’s stock, but such an action may be costly or even prohibited due to
regulatory and reputational issues associated with directors’ insider trading (see Leland, 1992;
John and Lang, 1991). An attractive alternative is to engage in “risk-substitution”. That is,
managers can choose to pass up innovative projects with high firm-specific risk in favor of
standard projects that are characterized by greater aggregate (systematic) risk, which is hedgeable
(see Garvey and Milbourn, 2003; Acharya and Bisin, 2009). Risk-substitution enables managers to
be better diversified in their personal portfolios, but it may also lead to suboptimal corporate
policies and lower firm valuation. For example, Gormley and Matsa (2016) show that managers’
risk preferences could be motivating them to reduce their firms’ risk through diversifying
acquisitions, an action that benefits managers but may adversely affect shareholder value.
In this study, we examine how managerial ownership influences firm value in light of the
trade-off between the alignment and the risk-substitution effects. We argue that, on the one hand,
managerial ownership may have a positive impact on firm value due to its alignment effect, but, on
the other hand, it may also have a negative impact due to its risk-substitution effect. To establish
the contingent nature of this relationship, we hypothesize that the net effect of managerial
ownership on firm value depends on the level of idiosyncratic risk of each firm, which essentially
determines the relative strength of the alignment and risk-substitution effects. A unique feature of
our study, as analytically discussed below, is the use of both parametric and semi-parametric
estimation methods, which enable us to capture potential nonlinear effects of managerial
ownership on performance in a more precise way.

1
Shleifer and Vishny (1997) provide an analytical discussion on the various ways in which management may not act
in a firm’s best interest. There is a large strand of empirical literature providing evidence on adverse effects of
managerial entrenchment on corporate policies and firm value (see, e.g., Gadhoum, 1999; Florackis et al., 2009;
Florackis et al., 2015).
2
See Morck et al. (1988), McConnell and Servaes (1990) and Hermalin and Weisbach (1991), among others.
3
 To identify firms exposed to severe risk-substitution problems, we follow a simple empirical
strategy. We argue that, under a manager’s point of view, idiosyncratic risk is typically more
difficult to hedge than aggregate risk (see Jin, 2002; Garvey and Milbourn, 2003). Rather than
adopting conventional hedging strategies (e.g. selling short their stake in the firm), managers of
high idiosyncratic risk firms typically choose to engage in risk-substitution. This reduces their
exposure to unhedgeable firm-specific risk but also leads to suboptimal investment policies (see
Acharya and Bisin, 2009; Panousi and Papanikolaou, 2012), which possibly offsets any alignment
effect of managerial ownership. Conversely, risk-substitution incentives are not high-powered in
low idiosyncratic risk firms. This is because a large equity holding in their own firm
predominantly exposes managers to market (aggregate) risk, which is hedgeable. Hence, managers
of low-risk firms are less likely to sacrifice profitability (e.g. through cutting specific investment
projects) for the sake of reducing their own risk exposure. As a result, managerial ownership may
prove a particularly useful mechanism to address managerial incentive problems in firms with a
low level of idiosyncratic risk.
On the basis of the preceding discussion, we hypothesize that the positive link between
managerial ownership and firm value is stronger (weaker) for firms with a low (high) level of
idiosyncratic risk. Using a large sample of US firms listed on NYSE, AMEX and NASDAQ, we
present evidence consistent with this hypothesis. Our findings support the contention that the
alignment effect of managerial ownership, which is only evident among the sample of low
idiosyncratic risk firms, is offset by the risk-substitution effect in high idiosyncratic risk firms,
which typically experience stronger risk-substitution problems.
We identify a plausible channel through which managerial risk aversion and risk-substitution
may lead to lower firm valuation. More specifically, we show that firms that are more exposed to
risk-substitution exhibit more “conservative” investment and financing policies; in particular,
lower levels of capital expenditures, a lower propensity to invest in R&D and lower leverage
ratios. We also identify a potential solution to the risk-substitution problem, which seems to be (at
least partially) mitigated by the inclusion of stock options in managerial compensation packages.
Last but not least, we document that the nonlinear relationship between managerial ownership
and firm value can be described more precisely within a semi-parametric setting. Our semi-
parametric estimates support only the alignment effect of managerial ownership, which occurs for
managerial ownership levels lower than 10 percent for the case of low-idiosyncratic risk firms.
These estimates do not support the existence of an entrenchment effect at higher levels of
managerial ownership, or any other turning points at intermediate or high levels of managerial

4
ownership, in contrast to the findings of Morck et al. (1988), McConnell and Servaes (1990), Cui
and Mak, 2002; Davies et al., 2005; and Benson and Davidson III (2009), among others. Even
though purely parametric methods yield findings that are consistent with those reported in prior
literature, we conclude that semi-parametric estimation methods capture nonlinearity more
precisely. This has important implications for future studies aiming at capturing nonlinear patterns
in corporate finance research.
The current study builds upon a growing literature that focuses on how managers’ exposure to
idiosyncratic risk, risk-substitution incentives and more generally how managers’ risk preferences
affect corporate outcomes. For example, Panousi and Papanikolaou (2012) show that risk-averse
managers tend to underinvest when idiosyncratic risk increases. They also find that the relation
between investment and idiosyncratic risk is stronger when managers own a larger fraction of the
firm. Glover and Levine (2017) document that most compensation contracts used by companies
require the manager to hold a significant proportion of their wealth in own-company stock and
options. This exposes the manager to idiosyncratic risk, distorts his/her choice of
investment/financial policies and adversely affects shareholder value. Jagannathan et al. (2016)
find that managers at firms with greater exposure to idiosyncratic risk use higher discount rates in
capital budgeting. This is partly driven by managerial risk aversion, which manifests itself as a
form of capital rationing that benefits managers but not the firm. Gormley and Matsa (2016) show
that managers with undiversified holdings have incentives to “play it safe” and reduce firm risk.
More specifically, by focusing on a state anti-takeover law that weakens shareholder governance,
they show that firms that are most affected by the law and have risk-averse managers, are more
likely to undertake diversifying, yet value destroying acquisitions, than similar firms unaffected by
the law.
Our study contributes to corporate governance research in several ways. To our knowledge,
this is the first study that considers the risk-substitution effect while developing a contingency
perspective on the relationship between managerial ownership and firm value. We argue that
unless the risk-substitution effect is properly accounted for, it may not be possible to reach a
consensus on whether (and at what levels) managerial ownership is value enhancing. By
documenting that idiosyncratic risk influences the strength of the relationship between managerial
ownership and firm value, we extend previous research from Panousi and Papanikolaou (2012),
Jagannathan et al. (2016), Gormley and Matsa (2016) and Glover and Levine (2017) that focuses
on how managers’ risk preferences affect certain corporate policies. While our analysis partly

5
focuses on corporate policies or strategic decisions in order to identify plausible channels for our
findings, it also extends to firm value and overall corporate performance.
Our study also builds on earlier research that tests for nonlinearities in the ownership-firm
value relation. Our approach to adopt a nonlinear specification is partly motivated by prior
evidence documenting the existence of nonlinear effects (see Morck et al., 1988; McConnell and
Servaes, 1990; Cui and Mak, 2002; Davies et al., 2005; Benson and Davidson III, 2009; Sueyoshi
et al., 2010) as well as the lack of consensus on the exact shape of the ownership-performance
curve. We build upon a relatively recent and yet developing strand of research that uses semi-
parametric methods and documents nonlinear effects of different dimensions of ownership
structure, such as executive ownership and ownership concentration, on firm outcomes (see
Florackis et al., 2009; Hamadi and Heinen, 2015; Florackis et al., 2015). More specifically, we
argue that the key issue with parametric approaches is that one has to exogenously impose the
turning points of the relationship and then estimate these models (see Keele, 2008). To the
contrary, the semi-parametric model employed in our study allows us to capture nonlinearity more
precisely. An important advantage of the methodology used in this study is that it does not pre-
specify ad hoc cut-off points and, hence, a highly restrictive parametric form in the relationship
between managerial ownership and firm value. By allowing the data to determine an appropriate
model rather than imposing a specific parametric assumption on the data generating process, our
method is not subject to the severe misspecification problems typically applied to purely
parametric methods (see Racine, 2008).
The paper proceeds as follows: Section 2 develops the empirical hypotheses tested in this
study. Section 3 describes the data sources, variables’ definitions and estimation methods
employed. Section 4 presents the benchmark empirical results, which are validated in Section 5
through a series of robustness checks. Section 5 also addresses the question of whether stock
options mitigate the risk-substitution problem and provides evidence on plausible channels behind
our results. Section 6 concludes.

2. Hypotheses Development
The insights of agency theory have become a central focus of corporate governance research. It is
presumed that conflicting interests between managers and shareholders arise from managerial
incentives to pursue courses of action that are inconsistent with the interests of shareholders
(Jensen and Meckling, 1976; Shleifer and Vishny, 1997). It is widely recognized that agency costs
can be particularly severe in the following two scenarios. First, when an organization generates a

6
substantial free-cash-flow that can be “dampened” through direct wealth expropriation by
managers (Jensen, 1986). Second, when risk-averse managers have strong incentives to substitute
firm-specific risk for aggregate market or industry risk, abandoning potentially highly profitable
projects (Acharya and Bisin, 2009). Such incentives arise because firm-specific risk is typically
more difficult to hedge than aggregate risk (Jin, 2002; Garvey and Milbourn, 2003).3
With respect to the cash-flow expropriation problem, managerial ownership has been
proposed as a potential solution (see Jensen and Meckling, 1976). Nevertheless, very little
attention has been paid on the potential costs associated with large managerial shareholdings,
which generate risk aversion and usually lead managers to undertake value destroying actions (see
e.g. Gormley and Matsa, 2016), such as risk-substitution. This study attempts to fill in this gap in
the literature by developing a contingency perspective on the relationship between managerial
ownership and performance that takes into account both the cash-flow expropriation and the risk-
substitution problems. We hypothesize that firms characterized by a low level of idiosyncratic risk
experience minimal risk-substitution problems. In such firms, a large managerial shareholding
does not necessarily expose managers to an excessive level of idiosyncratic risk and, as a result,
managerial incentives for risk-substitution are weak. Conversely, low idiosyncratic risk firms often
generate substantial free-cash-flow and therefore are exposed to severe cash-flow expropriation
problems, largely due to the lack of attractive investment opportunities and overinvestment (see
Jensen, 1986; Jensen, 1989; Cao et al., 2008). This implies that managerial ownership may prove
an important corporate governance mechanism for such firms. This leads to the following testable
hypothesis:

Hypothesis 1: For firms with a low level of idiosyncratic risk, managerial ownership and
firm value are positively related.

On the other hand, in companies characterized by a high level of idiosyncratic risk, cash-flow
expropriation problems are rarely an issue. This is because high idiosyncratic risk companies
usually have significant growth opportunities (see Cao at al., 2008) and operate with high
leverage, which by itself acts as a self-disciplining governance mechanism to mitigate the costs of
the manager-shareholder agency conflict (see Jensen, 1989; Holmstrom and Tirole, 2000). As a
result, free-cash-flow misuse is subdued in high idiosyncratic risk firms. This implies that the
3
For example, a manager can easily reduce her exposure to aggregate market risk implied by her firm’s shareholdings
by having a short position on the corresponding futures index. On the other hand, the only way to reduce her
idiosyncratic risk exposure is to have a short position on her firm’s stock; such a position is almost impossible to hold
due to regulatory requirements, reputational costs and/or contractual agreements.
7
alignment effect of managerial ownership is not expected to be particularly strong for these firms.
Conversely, high idiosyncratic risk companies face serious risk-substitution problems because
managers with substantial equity holdings may want to tilt their firm’s projects to aggregate risk
and, in this way, reduce their own exposure to unhedgeable firm-specific risk. Although risk-
substitution enables managers to be better diversified in their personal portfolios, it may also lead
to suboptimal investment decisions/strategic choices and, as a result, lower firm valuation (see
Panousi and Papanikolaou, 2012; Jagannathan et al., 2016; Gormley and Matsa, 2016). As a result,
an increase in managerial ownership is not expected to be value enhancing for the case of high
idiosyncratic risk firms. This leads to the following testable hypothesis:

Hypothesis 2: For firms with a high level of idiosyncratic risk, the positive relationship
between managerial ownership and firm value, if any, becomes considerably weaker.

3. Research Design
3.1. Data
Our initial sample includes all firms listed on NASDAQ, NYSE and AMEX. We compile our
dataset from several sources. We use Board Analyst to obtain detailed information on corporate
board structure, ownership structure and several other board and director characteristics. We limit
our sample period to 2001-2007 due to insufficient data availability in other years (e.g. data
provided by Board Analyst are either unavailable or incomplete prior to 2001 and after 2007). We
match Board Analyst data at a company level with accounting and market data obtained from
Thomson Reuters Datastream. These data are supplemented by information on excess market
returns and the size, value, momentum, profitability and investment factors, which are obtained by
Kenneth French’s online data library.4 Compensation data that are required for the calculation of
the incentive measures are available in Standard & Poor’s ExecuComp database. For some of our
robustness tests, we also use option-implied volatility as an alternative measure of firm risk, which
is sourced from OptionMetrics. Starting with 2,295 companies that appear both in Board Analyst
and Thomson Reuters Datastream, we impose several screening criteria to our dataset. First, we
exclude firm-year observations with missing values for any of the key variables. Second,
following standard practice in the literature, we exclude firm-year observations that lie outside the
1st and 99th range for each variable.5 Third, we remove from the dataset all non-US firms that are

4
This data library is accessible at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
5
For robustness purposes, rather than excluding outliers, we repeat our analysis after winsorizing our data (by year) at
the 1% and 99% levels. The results are qualitatively similar in both cases.
8
listed on NASDAQ, NYSE and AMEX, and also exclude ADRs, REITs, subsidiaries and OTC
firms because of their different regulatory, reporting and administrative regimes. Data for all
variables are reported in financial year end. These criteria lead to a sample that comprises of 1,969
firms and 7,295 firm-year observations for our benchmark analysis.
3.2. Variables
This section outlines the dependent and explanatory variables used in our empirical models.
Detailed description for variable definitions and codes are provided in Table 1.
Firm Value/Performance: We use Tobin’s Q as our key performance indicator, which is
measured as the ratio of the book value of assets minus the book value of equity plus the market
value of equity to the book value of assets. For robustness purposes, we use two additional
performance measures, namely ROA (the ratio of net income to total assets) and Enterprise Value
(the sum of market value of equity and total debt divided by total sales).
Managerial Ownership: Since Jensen and Meckling’s (1976) seminal study, managerial
ownership has been suggested as a key determinant of firm value. In this study, it is defined as the
percentage of shares held by the management and directors (MANAGERIAL OWNERSHIP). For
robustness purposes, we also use the dollar value of managerial ownership (DOLLARMAN) as an
alternative measure of incentives.
Idiosyncratic Risk: The benchmark idiosyncratic risk proxies utilized in our study are based
on a set of widely used measures of stock returns’ idiosyncratic volatility. Since our aim is to
measure firm idiosyncratic risk, an asset-pricing model is needed to decompose total stock return
volatility into its systematic and idiosyncratic components. The use of the CAPM is the traditional
textbook approach to perform such decomposition. Despite several attractive features (e.g.
systematic risk is fully captured by one parameter), the CAPM is not without limitations. For
example, its inability to explain certain patterns in average stock returns (e.g. the high average
returns of small/value stocks relative to big/growth stocks) has led researchers to consider
alternative asset pricing models. Following Fama and French’s (1993) seminal study, the 3-factor
model, which includes the so-called size and book-to-market risk factors, has become a common
approach to measure idiosyncratic risk in the empirical asset pricing literature. 6 While the 3-factor
model explains the patterns in returns observed when portfolios are formed on earnings/price, cash
flow/price, and sales growth (see Fama and French, 1996), it cannot explain the continuation of
short-term returns documented by Jegadeesh and Titman (1993). This has led to the development

6
An indicative list of studies that use the Fama and French (1993) 3-factor model includes Ang et al. (2006), Bali and
Cakici (2008), Fu (2009), and Boyer et al. (2010).
9
of the Carhart (1997) 4-factor model, which controls for the so-called momentum anomaly in
stock returns.7
In the present study, we use idiosyncratic risk proxies derived from each of these models. For
our benchmark analysis, however, we focus on Fama and French’s (2015) 5-factor model, which
seems to perform better than any other alternative. In particular, we estimate the 5-factor model of
Fama-French (2015) for each stock i as follows:

𝑅𝑖𝑡 − 𝑅𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖,𝑀𝐾𝑇 𝑀𝐾𝑇𝑡 + 𝛽𝑖,𝑆𝑀𝐵 𝑆𝑀𝐵𝑡 + 𝛽𝑖,𝐻𝑀𝐿 𝐻𝑀𝐿𝑡 (1)

+ 𝛽𝑖,𝑅𝑀𝑊 𝑅𝑀𝑊𝑡 + 𝛽𝑖,𝐶𝑀𝐴 𝐶𝑀𝐴𝑡 + 𝜀𝑖𝑡

where MKT is the excess market return in period t, and SMB, HML, RMW and CMA stand for the
size, value, profitability and investment risk factor returns, respectively. Idiosyncratic risk of stock
i is measured as the standard deviation of residuals from Equation (1), i.e., ID_RISK (FAMA-
FRENCH 5-Factor)= √𝑉𝑎𝑟(𝜀𝑖𝑡) . For these measures to be consistent with our data on firm value
and managerial ownership, the estimation of ID_RISK (FAMA-FRENCH 5-Factor) is performed
on an annual basis using weekly observations.8 For the estimation, we obtain weekly data for the
excess market returns, the size, value, momentum, profitability and investment factor returns by
Kenneth French’s online data library. Using the 33th and 67th percentiles as cut-off points, firms
that exhibit a high (low) standard deviation in the residual term are classified as high (low)
idiosyncratic risk firms.
For robustness purposes, we also use alternative measures of firm risk. In particular, we use
stock returns’ idiosyncratic skewness and option-implied volatility. Section 5 provides details on
the definitions of these measures and presents the corresponding results. As discussed in Section 5,
we also use proxies derived from alternative asset pricing models and a time varying risk measure.

[Insert Table 1 about here]

Controls: A set of controls is used in our empirical models to “partial out” the effect of other
variables on Tobin’s Q. Following prior studies, our list of control variables includes both
accounting measures (dividend payout, investment, cash holdings, firm size) and corporate
governance measures (board structure, board size and several other board and director
characteristics). Our complete list of control variables with their respective definitions are

7
See, e.g., Cao et al. (2008), McLean (2010) and Huang et al. (2010) for some empirical applications of this model.
8
Our results do not change if we use daily returns data for constructing idiosyncratic risk proxies.
10
provided in Table 1. Analytical descriptive statistics for all the variables used in the empirical
analysis are presented in Table 2.

[Insert Table 2 about here]

3.3. Methodology
We employ both parametric and semi-parametric methods to examine the effect of managerial
ownership on firm value. Following Jensen and Meckling (1976), the early studies on the subject
assume a linear parametric form for all explanatory variables by estimating the following equation:

E (Q / Man, X )    X   Man (2)

where Q denotes Tobin’s Q, Man denotes managerial ownership and X is a vector that includes the
set of control variables in the model. To allow for potential nonlinearities in the managerial
ownership-firm value relationship, subsequent studies use managerial ownership values up to the
pth power as regressors (e.g., McConnell and Servaes, 1990; Cui and Mak, 2002; Davies et al.,
2005; Fabisik et al., 2018). Following this line of inquiry, our benchmark analysis considers the
specification that is most widely used in the literature. Specifically, we allow for the conditional
mean of Q to take the form:

E (Q / Man, X )    X  1Man   2 Man2 (3)

We measure our dependent variable at time t, while for the explanatory variables t-1 values are
used.9 In addition to the above parametric specification, which is restrictive and not based on solid
theoretical foundations, we also put forward a semi-parametric model. The semi-parametric model
relaxes the functional form on Man but still controls for the other factors (in X) that determine firm
value in a parametric way. In this case, the conditional mean of the model is given by:

E (Q / Man, X )    X  f (Man) (4)

9
We follow prior literature and use lagged values of all explanatory variables (see e.g., Hermalin and Weisbach, 1991;
Palia and Lichtenberg, 1999; Callahan et al., 2003; Brick et al., 2006; Cornett et al., 2008). The use of one-year lags in
our setting allows us to take into account the fact that changes in board/ownership structure are only fully reflected in
firm performance with a lag.
11
where   X represents the parametric component and f (Man) the non-parametric one. 10
For our benchmark results, the non-parametric component f (Man) is estimated using thin plate
regression splines with optimal basis functions. The employed methodology minimizes the
following objective function:

1 n 
min  (Qi  f ( Mani )    X )2   J ( f )  (5)
 n i 1 
where J(f) represents the roughness of the function f and n denotes the number of observations.
Equation (5) describes the trade-off between fitting perfectly the data (i.e. minimizing the squared
residuals) and having the smoothest possible approximating function f. This trade-off is controlled
by parameter  . As  →∞, the penalty assigned to the roughness of the function is so high that the
optimal function, f, is of linear form, since, by definition, a linear function has zero roughness for
the whole range of the dependent variable values. In this case, the minimization problem becomes
identical to least squares. On the other extreme, if  →0, then this methodology will provide a
very rough approximating function f that essentially fits each individual observation. The selection
of this parameter  is based on the Generalized Cross Validation (GCV) criterion. According to
this criterion, the optimal  minimizes the following expression:

RSS   
GCV     (6)
1  n 1tr  S     
2

 
where RSS     ee is the sum of squared residuals of the estimated model for a given  and
tr  S     is the trace of the projection matrix S ( ) that satisfies Q  SQ . For each of the models


estimated, the corresponding minimized GCV score is also reported. Our analysis is based on a
pooled semi-parametric panel11 estimated using the gam function of the mgcv package in R.12

4. Benchmark Results

10
We only allow managerial ownership to enter the model specification in a non-parametric way because this way it
allows our findings to be directly comparable with those reported in prior literature (e.g. Morck et al., 1988;
McConnell and Servaes, 1990; Cui and Mak, 2002; Davies et al., 2005; and Benson and Davidson III, 2009). Please
also note there is no (strong) evidence that any of our control variables relates to firm performance in a non-linear
way. We hence consider a standard parametric specification for our control variables.
11
A useful extension would involve a semi-parametric random or fixed effects estimation in the spirit of Hamadi and
Heinen (2015).
12
The Appendix provides further details on the employed semi-parametric method.
12
Table 3 reports the results for low idiosyncratic (Panel A) and high idiosyncratic (Panel B) risk
firms as classified according to the variable ID_RISK (FAMA-FRENCH 5-Factor).13,14 To ensure
robustness, we utilize both parametric and semi-parametric methods for our estimations.
Appropriate statistical tests are carried out to evaluate the ability of each method to capture
potential nonlinearity in the relationship between managerial ownership and Tobin’s Q.
The parametric results clearly support both empirical hypotheses developed in Section 2. In
particular, consistent with Hypothesis 1, managerial ownership exhibits a positive and statistically
significant association with Tobin’s Q for the case of low idiosyncratic risk companies; the
estimated coefficient for the level managerial ownership term is 1.327 (t=3.41). The economic
magnitude of the coefficient is also significant. For instance, increasing managerial ownership
from the 25th percentile (3.14%) to the 50th percentile (7.90%) increases Tobin’s Q by 6.31%. To
put this magnitude into perspective, we note that the market value for the average firm in our
sample is $1.635 billion. Thus, a 6.31% increase corresponds to a $103.16 million increase in firm
value. This positive relationship turns into negative at higher levels of managerial ownership (i.e.
the coefficient of the squared term of managerial ownership is found to be negative at -2.109 and
statistically significant (t=-2.97), which supports the entrenchment effect of managerial ownership.
Conversely, there is no evidence supporting a significant effect of managerial ownership on
Tobin’s Q for the case of high idiosyncratic risk firms, which is in line with Hypothesis 2. More
specifically, as shown in Panel B, both the level and squared terms of managerial ownership terms
appear to be statistically insignificant (t = 1.12 for the level term and t = -0.99 for the squared
term). The adjusted R2 statistics show that the utilized model can explain 37.28% (28.50%) of the
variation in firm value for the case of low (high) idiosyncratic risk firms. The different explanatory
power of the models is explained from the fact that managerial ownership does not play an
important role in explaining firm value for high idiosyncratic risk firms (Panel B).15

[Insert Table 3 about here]

13
For robustness purposes, we have repeated our analysis using idiosyncratic risk proxies estimated from the CAPM,
Fama-French 3-factor and Carhart 4-factor models. We conclude that our results are not sensitive to the choice of asset
pricing model. We report the results based on Carhart’s 4-factor model in Tables S.1 and Figures S.1 and S.2 of the
Supplementary Internet Appendix. The results based on the CAPM and Fama-French 3-factor model are available
upon request.
14
The use of subsample analysis is more relevant for our setting as it enables the results from the parametric
estimation to be directly comparable with those from the semi-parametric one. Nevertheless, we check the robustness
of our subsample analysis by conducting full sample estimation and using interaction terms in Section S.2 of the
Supplementary Internet Appendix.
15
In Section S.3 of the Supplementary Internet Appendix, we re-estimate our benchmark specification after including
firm fixed effects. We do this to account for omitted variable bias and/or unobserved time-invariant heterogeneity that
might be driving our results. The results, as presented in Table S.3, remain consistent with our main findings.
13
 Examining the semi-parametric results, the estimated managerial ownership-firm value curve
has a positive and relatively steep slope for the case of low idiosyncratic risk companies, though
only for low ownership values (see Figure 1). The confidence bounds (dashed lines) are narrow for
relatively low levels of managerial ownership (i.e. <10%), indicating the existence of a strong
alignment effect. Such an effect may be followed by an entrenchment effect at higher levels of
managerial ownership, but no strong conclusions can be drawn due to the wide confidence bounds.
For the group of high idiosyncratic risk companies, however, it seems that managerial ownership
is not significantly associated with firm value. As shown in Figure 2, the curve that depicts the link
between managerial ownership and Tobin’s Q does not conform to any significant relationship
between the two variables. Based on these findings, we conclude that there is no statistical
significant link between managerial ownership and Tobin’s Q for high idiosyncratic risk firms.

[Insert Figures 1&2 about here]

The notable differences in the inferences drawn from our parametric and semi-parametric
evidence encourage us to conduct some additional analysis. In particular, we conduct full-sample
estimations of various performance models that include managerial ownership polynomials of the
degree of 2, 3, 4 and 5 (as in McConnell and Servaes, 1990; Cui and Mak, 2002 and Davies et al.,
2005). This analysis enables us to conduct a direct comparison of our findings with those reported
in prior literature. We present and discuss the results in Table S.4 of the Supplementary Internet
Appendix. The key inference of this analysis is that had we used a purely parametric method and
not conditioned upon idiosyncratic risk, our findings would have been consistent with those
reported in prior literature (e.g. Morck et al., 1988 and McConnell and Servaes, 1990). However,
the semi-parametric results presented in this section cast doubt on the standard (parametric)
approaches to investigate the relationship between ownership and firm performance. Specifically,
based on our semi-parametric estimates, we provide evidence supporting only the initial alignment
effect of managerial ownership, which occurs for managerial ownership levels lower than 10
percent. The results are far from conclusive for managerial ownership levels greater than 10
percent.
The latter finding contrasts previous findings in the literature, which indicate a specific
varying relationship between managerial ownership and performance at intermediate and high
levels of managerial ownership. For example, Morck et al. (1988) document a positive relationship
between managerial ownership and firm value at low levels of ownership (i.e., 0% to 5%), a
negative relationship at intermediate levels (i.e., 5%-25%) and again a positive relationship at high

14
levels (i.e., above 25%). McConnell and Servaes (1990) find an inverted U-shaped relationship
between managerial ownership and firm value, with the turning point between 40% and 50%.
Several prior studies utilize even more complicated specifications to model this relationship. For
example, Cui and Mak (2002) report that firm value initially declines as managerial ownership
increases from 0% to 10%, increases between 10% and 30% ownership levels, declines again
between 30% and 50% ownership levels, and then rises again above 50% equity ownership,
suggesting a W-shaped relationship for the case of high R&D firms. Davies et al. (2005) employ a
quintic specification and suggest five turning points in the relationship between managerial
ownership and firm value. They report that firm value increases when managerial ownership is
less than 7%, decreases between 7% and 26%, increases between 26% and 51%, decreases again
until managerial ownership reaches to 76% and then increases again. We argue that these findings
can be largely attributed to the method used to capture the nonlinear nature of the relationship.
The results presented in Table 3 also yield several interesting findings with respect to the
impact of control variables on firm value. Starting with the accounting variables, investment and
cash holding are strong determinants of Tobin’s Q, both for the low idiosyncratic risk and high
idiosyncratic risk companies. In line with prior literature, firm size and dividend enters with a
positive coefficient in all specifications considered. Among the set of board /corporate governance
characteristics considered, the variable OTHER_CEO_DIRECTORS has a negative and
statistically significant coefficient in the models for high idiosyncratic risk firms (based on both
parametric and semi-parametric estimates). This finding suggests that, ceteris paribus, high-risk
firms whose directors act as CEOs in other companies exhibit lower valuations compared to
companies whose directors do not hold senior positions elsewhere. There is also some evidence
that busy directors result in lower firm valuations; the variable BUSY_DIRECTORS has a
negative coefficient, though this is not consistently statistically significant. Finally, our findings
strongly support the well-documented negative link between board size and Tobin’s Q (i.e. the
variable BOARDSIZE has a negative and statistically significant coefficient in all models
considered).
Taken together, the results presented in Table 3 infer that the nature of the ownership-
performance relationship varies across firms exposed to different levels of idiosyncratic risk. Both
parametric and semi-parametric methods suggest that, at low levels, managerial ownership affects
value in a strong positive way, but this effect applies only for low idiosyncratic risk companies
that are not exposed to severe risk-substitution problems. To this end, our study relates to the
broader literature (see e.g. Cui and Mak, 2002; Cheung et al., 2006; Florackis et al., 2009; Fabisik

15
et al., 2018) suggesting that several firm-specific characteristics such as firm size, capital structure,
growth opportunities, cumulative past performance and liquidity can significantly determine the
way in which managerial ownership affects firm value. An important implication of our results is
that unless risk-substitution is properly accounted for, it may not be possible to reach a consensus
on whether (and at what levels) managerial ownership is value enhancing.

5. Further Evidence
5.1 Robustness Tests
5.1.1 Idiosyncratic Skewness and Implied-Volatility
In addition to being averse to volatility, managers are likely to exhibit aversion to negative
skewness and preference over positive skewness. This behavior has been termed as prudence by
Kimball (1990) and it is linked to the precautionary motive of Leland (1968). Harvey and Siddique
(2000) have empirically documented that skewness is an important dimension of risk. Mitton and
Vorkink (2007) have shown that, apart from the systematic component of skewness (co-skewness),
stock returns’ idiosyncratic skewness may be a priced risk factor too. To capture this dimension of
idiosyncratic risk, we use an additional measure. Specifically, in line with Boyer et al. (2010), we
estimate idiosyncratic skewness as follows:

ID _ RISK  SKEWNESS  
1  t  it3

(7)
3
T 1 
  t  it 
2

 T 

where  it stands for the residual series estimated from the Fama-French 5-factor model and T
refers to the numbers of weeks in each year. The model is estimated on a yearly basis using
weekly data.
Companies are assigned into each idiosyncratic risk group according to their ID_RISK
(SKEWNESS) using the 33rd and 67th percentiles as cut-off points. In particular, firms with the
most negative estimated values of ID_RISK (SKEWNESS) are classified as high idiosyncratic risk,
since negative idiosyncratic skewness is the undesirable feature of stock returns that managers
would be averse to. Likewise, firms with the most positive estimated values of ID_RISK
(SKEWNESS) are classified as low idiosyncratic risk, since managers would prefer to hold stocks

16
exhibiting this feature (see Mitton and Vorkink, 2007). Table 4 and Figures 3 and 4 present the
corresponding estimation results for low (Panel A) and high (Panel B) idiosyncratic risk firms.
These results corroborate the ones reported in Section 4.

[Insert Table 4 about here]

[Insert Figures 3&4 about here]

For completeness, we have also used option-implied volatility as an alternative measure to

capture firm risk. The advantage of this approach is that option prices embed forward-looking
information. The downside is that a substantial number of firms drop out of our sample because
they had not issued options or this information is not available in OptionMetrics during the
examined time period. This is particularly true for relatively small capitalization firms that also
exhibit relatively high idiosyncratic risk, leading to a potential sample selection bias. Nevertheless,
we source 30-day, at-the-money, daily implied volatilities from the corresponding Volatility
Surface file provided by OptionMetrics. The corresponding measure of firm risk is given by the
annual average of these daily implied volatilities. A minimum number of 50 daily observations are
required to compute the annual average. Matching our sample of firms with OptionMetrics, we
have computed annual implied volatilities for 1,083 unique firms. Equipped with this alternative
proxy for firm risk, we have re-examined the relationship between firm value and managerial
ownership.
[Insert Table 5 about here]
[Insert Figures 5&6 about here]

Table 5 and Figures 5 and 6 present the corresponding estimation results for low (Panel A)
and high (Panel B) risk firms. In line with the evidence presented so far, we find that the positive
relation between managerial ownership and Tobin’s Q is still preserved in the sample of low risk
firms, as classified on the basis of their implied volatilities. However, the confidence bands seem
to be larger than those in Figure 1 at around the 10% level of managerial ownership, which may be
largely explained by the decrease in the sample size. To the contrary, as expected, there is no
statistically significant relation between managerial ownership and Tobin’s Q for high risk firms.
These results hold under both parametric and semi-parametric estimation methods.

5.1.2 Evidence from Time-Varying Risk Measures

To capture the potentially time-varying nature of idiosyncratic risk, we have also estimated an
EGARCH(1,1) model. While we follow Bali and Cakici (2008) in estimating the EGARCH (1,1),
17
we acknowledge that the lag structure of the GARCH-type model used should be selected on the
basis of standard information criteria (see Bekiros, 2014). Accordingly, we have alternatively
estimated the following models: EGARCH(1,1), EGARCH(1,0), EGARCH(2,1), and EGARCH
(2,2). We find that, despite the different lag structure that these models exhibit, their estimates of
time-varying volatility are similar. Most importantly for the purposes of our study, the
classification of firms into high and low idiosyncratic risk categories is not materially affected by
the different lag structures. To select the most appropriate EGARCH model for our analysis, we
have computed the corresponding values of the Akaike and Schwartz information criteria. We do
not find a specific model to uniformly dominate the rest across all firms and years in our sample.
However, we find that on the basis of the average values of the information criteria, the EGARCH
(1,1) model is a fair choice.
Accordingly, we split firms into low and high idiosyncratic risk categories according to their
average conditional idiosyncratic standard deviation, estimated using an EGARCH (1,1) model, as
analytically explained in Section S.5 of the Supplementary Internet Appendix. As shown in Table
S.5 and Figures S.3 and S.4, our results remain robust to the use of a time-varying measure of
idiosyncratic risk.

5.1.3 Alternative Splines

Thin plate regression splines are based on the idea of truncating the space of wiggly components
of the thin plate spline while leaving the components of ‘zero wiggliness’ unchanged. They are
characterized by the important property of not having to choose knot locations, a problem
encountered by other splines, and are computationally efficient. Thin plate regression splines
provide the best approximation for the behaviour of a thin plate spline using a basis of any given
low rank. They also retain the rotational invariability of full thin plate splines (Wood, 2006). For
these reasons, we rely on this type of splines in our benchmark empirical estimations.
For robustness purposes, in addition to using thin plate regression splines, we re-estimate
our benchmark semi-parametric specification for the case of low-idiosyncratic risk firms using
Wood’s (2006) Cubic Regression Splines and Cyclic Cubic Regression Splines, Eilers and Marx’s
(1996) P-splines and Krivobokova’s et al. (2008) Adaptive Smoother. The results, which are
presented in Section S.6 of the Supplementary Internet Appendix, verify in all cases the strong
positive association between managerial ownership and firm value at low levels of managerial
ownership. Overall, our findings are not sensitive to the spline basis used.

18
5.1.4 Alternative Cut-off Points
In our main analysis, we use the 33th and 67th percentiles of the variable ID_RISK (FAMA-
FRENCH 5-Factor) to classify firms into low and high idiosyncratic risk groups. The classification
is done by year and industry. To ensure that our results are not driven by the choice of these cut-
off points, we re-estimate our benchmark specifications using less extreme cut-off points and in
particular the 45th and the 55th percentiles. The results, which are not presented in the main body
of the paper but are part of the Supplementary Internet Appendix (see Section S.7) corroborate our
main findings.

5.1.5 Alternative Measure of Incentives

We also check the robustness of our results to an alternative measure for managerial incentives.
More specifically, motivated by the findings of Baker and Hall (2004) and Fenn and Liang (2001),
we use the dollar value of managerial ownership, DOLLARMAN, as the primary explanatory
variable of interest. The results, as are reported in Table S.7 and Figures S.9 and S.10 of the
Supplementary Internet Appendix, support Hypotheses H1 and H2 and demonstrate that the
previously reported results are unlikely to be driven by our definition for managerial ownership.

5.1.6 Alternative Performance Measures

The results presented thus far are based on Tobin’s Q, which is widely used in the literature as a
forward-looking performance measure (see, for example, Morck et al., 1988; McConnell and
Servaes, 1990; Davies et al., 2005). This is because the market value of a firm reflects investors’
expectations about its future economic performance (Patell, 1976). Being a market measure,
Tobin’s Q is less susceptible to changes in accounting practices (Chakravarthy, 1986; Bharadwaj
et al., 1999). A potential drawback of measuring performance through Tobin’s Q is that stock
prices do not always reflect the fundamental value of a company but also potential behavioural
biases such as investor overconfidence and loss aversion (Daniel et al., 1998; Barberis et al.,
2001). Another potential issue relates to the distorting effects of merger accounting on Q-based
measures (see e.g. Custodio, 2014). We therefore supplement our analysis with models that are
based on two additional performance measures. Following Anderson and Reeb (2003), and
Bebchuk et al. (2009), we firstly consider Return on Assets (ROA) (based on both net income and
EBITDA). Motivated by Custodio’s (2014) study and following Bhojraj and Lee (2002), we also
use enterprise value-to-sales (the sum of market cap and long-term debt divided by net sales). The

19
results, as reported in Section S.9 of the Supplementary Internet Appendix corroborate the findings
obtained using Tobin’s Q.

5.1.7 Evidence from Piecewise Regressions

One important feature of the semi-parametric approach employed in our study is that it does
not pre-specify ad hoc cut-off points (see Keele, 2008). This renders it more appropriate for
capturing non-linear features in the data.
For completeness, in Section S.10 of the Supplementary Internet Appendix, we estimate a
piecewise regression model that allows for changes in the slope of the relationship between Man
and Q on each side of a known, theoretically justified, cut-off point. Since one cannot observe
such a cut-off point ex-ante, we present evidence based on the cut-off points of 5% and 25% as
suggested by McConnell and Servaes (1990). We also present results using the 10% and 30% as
alternative cut-off points, which were selected based on a visualization of what functional form of
the regression function looks like in Figure 1 of our paper (that is, our semiparametric estimate of
the relationship between Man and Q). The results as presented in Table S.9 support the
conclusions derived from the semi-parametric analysis as presented in the main body of our paper.

5.2 Do Stock Options Mitigate Risk-Substitution Problems?

In this section, we focus on the question of how risk-substitution problems can be resolved. We
provide some preliminary insights by considering stock options and their ability to mitigate risk-
substitution incentives. Our rationale is based on the view that stock options provide risk-averse
managers incentives to alter their firms’ risk profile (see e.g. Smith and Stulz, 1985; Armstrong
and Vashistha, 2012; Milidonis and Stathopoulos, 2014; Heron and Lie, 2017). We conjecture that
stock options may alter firms' risk profile in a way that resolves the problem of substituting
idiosyncratic for systematic risk. Accumulating evidence supports this claim by showing that,
under certain conditions, stock options result in managers taking on more idiosyncratic risk. For
example, Armstrong and Vashistha (2012) find that stock options can alter managers’ risk-appetite
and increase idiosyncratic risk through their sensitivity to stock price (or delta). The positive
relationship between option delta and idiosyncratic risk demonstrates the existence of a strong
“wealth effect”, which encourages managers to pursue projects that are primarily characterized by
idiosyncratic risk even though it cannot be hedged. Along similar lines, Heron and Lie (2017)
show that executive stock options provide executives with an incentive to inflate risk, especially
idiosyncratic risk. In light of these findings, we hypothesize that, in the presence of stock options

20
in managerial compensation packages, the net effect of managerial ownership on firm value
depends on the relative strength of risk-substitution (incentive to decrease idiosyncratic risk) and
wealth (incentive to increase idiosyncratic risk) effects. Assuming that stock options discourage
risk substitution, one may argue that the wealth effect dominates the risk-substitution effect.
Table 6 presents some evidence supporting the view that stock options can at least partly
mitigate the risk-substitution problem. In particular, we re-examine the relationship between
managerial ownership and firm value for firms that have both a high level of idiosyncratic risk and
a high option delta. Our parametric and semi-parametric estimates (see Panel A of Table 6 and
Figure 7) suggest that there is a positive and statistically significant relationship between
managerial ownership and firm value in this group of firms. This can be interpreted as evidence
that the wealth effect dominates the risk-substitution effect. Conversely, the relationship between
managerial ownership and firm value remains insignificant for the group of high idiosyncratic risk
firms with low option delta. For the latter group of firms, it seems that the risk-substitution effect
dominates the wealth effect, which possibly explains the statistically insignificant results (see
Panel B of Table 6 and Figure 8).
Overall, our findings suggest that large managerial shareholdings induce risk-substitution and,
hence, they may be detrimental to firm value. However, appropriate compensation packages that
involve stock options with high option delta help mitigate the risk-substitution problem.

[Insert Table 6 about here]

[Insert Figures 7&8 about here]

5.3 Risk-Substitution, Managerial Risk Aversion and Corporate Policies

A key argument in our paper, which forms the basis for our main hypotheses, is that managers of
high-risk firms who are inherently undiversified might engage in sub-optimal investment/ financial
decisions (such as cutting down investments and reducing leverage) in order to reduce their own
exposure to idiosyncratic risk. Such actions have negative implications for shareholder wealth.
This view is also supported by empirical evidence showing that poorly diversified managers tend
to under-invest when idiosyncratic risk increases (see e.g., Panousi and Papanikolaou, 2012).
Thus, if higher managerial ownership creates risk-substitution incentives at high-idiosyncratic risk
firms, one would expect the managers at such firms to pursue more conservative and low-risk
strategies.
In this section, we emphasize on firms that are highly exposed to risk-substitution problems,
namely those that combine high levels of idiosyncratic risk and managerial ownership. Our
21
objective is to examine how risk-substitution incentives influence corporate policies. Such analysis
enables us to identify potential channels through which managerial ownership influences firm
value. We focus on the following investment and financial policies: Capital Expenditure, defined
as the ratio of capital expenditure to lagged net property, plant and equipment (see Coles et al.,
2006; Panousi and Papanikolaou, 2012); R&D Expenditure, defined as the ratio of research and
development expenses to lagged total sales (see e.g., Bebchuk and Cohen, 2005; Cassel et al.,
2012; Ferris et al., 2017); Market Leverage, defined as the ratio of total debt (long term debt plus
short term debt) to total assets minus book value of equity plus market value of equity (see Coles
et al., 2006); and Financial Leverage, defined as the ratio of total debt (long term debt plus short
term debt) to total assets (see Coles et al., 2006)
The results, as presented in Table 7, show that firms exhibiting both high managerial ownership
and high idiosyncratic risk are more likely to cut back on investments, as evidenced by their lower
levels of capital and R&D expenditures. We find that these firms also have lower levels of market
and financial leverage. These findings support our conjecture that low managerial diversification
may generate risk-substitution incentives, which in turn leads into more conservative (investment
and financial) policies. This possibly explains why the alignment effect of managerial ownership is
not present for the case of high idiosyncratic risk firms. Increasing the managers’ ownership stake
in such firms may actually worsen rather than mitigate the agency conflict between managers and
shareholders. These additional results help reconcile our main findings and provide new evidence
on potential channels through which managerial ownership may become detrimental for firm
performance in high idiosyncratic risk firms.

[Insert Table 7 about here]

6. Conclusions
Managerial ownership has been proposed as a potential solution to agency problems between
managers and shareholders, which are prevalent in modern corporations. In addition to its well-
documented alignment effect, managerial ownership also has value-destroying effects by shifting
risk to managers. In particular, in an attempt to reduce their personal portfolio’s exposure to
practically unhedgeable firm-specific risk, managers may pass up innovative projects with high
firm-specific risk in favor of standard projects that have greater aggregate market or industry risk,
which is hedgeable. This behavior may offset the alignment effect of managerial ownership in
firms exposed to severe risk-substitution problems, leading to lower firm valuation.

22
 In this study, we examine how managerial ownership relates to firm value in light of the trade-
off between the alignment and the risk-substitution effects. We carefully construct a dataset
comprising 1,969 US listed companies on NYSE, AMEX and NASDAQ and test hypotheses
regarding the shape of the ownership-value relationship using parametric and semi-parametric
methods. Our findings provide strong evidence supporting the existence of a risk-substitution
effect associated with large managerial shareholdings. Our results are in line with our contingency
argument that the alignment effect of managerial ownership is negligible for high idiosyncratic
risk firms, which suffer from severe risk-substitution problems. Conversely, managerial ownership
seems to be a particularly effective governance mechanism for the case of low idiosyncratic risk
firms. We identify a plausible channel for these effects by showing that firms exposed to risk-
substitution exhibit more “conservative” investment and financing policies. We also show that the
risk-substitution problem is partially mitigated by the inclusion of stock options in managerial
compensation packages.
Several important implications emerge from our empirical results. First, we show that risk-
substitution problems do matter. Firms that exhibit both high managerial ownership and
idiosyncratic risk are more likely to cut back on investments, as evidenced by their lower levels of
capital and R&D expenditures. These firms also adopt more conservative financial policies, as
evidenced by their lower market and financial leverage ratios. Understanding the relevance of
these agency conflicts is crucial for designing mechanisms that align the interests of managers
with those of shareholders. We show that increasing managers’ ownership stake in the firm does
not always mitigate the agency conflict between managers and shareholders.
Our analysis suggests that unless the risk-substitution effect of managerial ownership is
properly accounted for, it may not be possible to reach a consensus on whether (and at what levels)
managerial ownership matters for corporate performance. Based on the evidence presented in our
study, we can argue that an increase in managerial ownership may actually worsen agency
conflicts for firms with high exposure to idiosyncratic risk. To the contrary, the award of stock
options (e.g. convex payoffs) may help resolve the risk-substitution problem. Finally, our findings
have an important methodological implication for empirical corporate finance researchers. We
show that the nature of the relationship between managerial ownership and firm value can be
described more precisely within a semi-parametric setting. This has important implications for
future studies aiming at capturing nonlinear patterns in corporate finance research.

23
Appendix
An important feature of the semi-parametric method is that it allows the construction of
 
confidence bands for the fitted spline Q  SQ . Its covariance matrix is given by cov(Q)  SS  2 ,
where  2 is the residuals’ variance. Given an unbiased estimator for this variance and a large
sample size, we can form approximate 95% pointwise confidence interval bands, using 2 times
the square root of 𝑆𝑆 𝑇 𝜎̂ 2 . These confidence bands along with the fitted spline are illustrated in the
figures presented in Sections 4 and 5. We are also able to test the statistical significance of the
non-parametric component in the specified semi-parametric model. This is done via an F-test that
compares the sum of squared residuals (RSS) of the semi-parametric model (unrestricted) with the
RSS of the restricted model that excludes the non-parametric component altogether. The
corresponding F statistic is given by:

 RSSrestricted  RSSunrestricted  /  tr  S   1
F (8)
RSSunrestricted / df res ,unrestricted


where df res  n  tr (2S  SS ) . This test statistic under the null hypothesis of equal RSS follows an
approximate F-distribution with df res ,restricted  df res ,unrestricted and df res ,unrestricted degrees of freedom.

24
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28
 TABLE 1
Variable Definitions
Variable Name Definition Data Items used
Tobin’s Q Ratio of the book value of assets minus the book value DataStream items: MV,
of equity plus the market value of equity to the book value WC03501, WC03451,
of assets WC02999
ROA The ratio of net income to total assets DataStream items:
WC18191, WC01451,
WC02999
ENTERPRISE VALUE The ratio of enterprise value (EV) to total sales. EV is the DataStream items: MV,
sum of market value of equity and total debt. WC03255, WC01001

CAPITAL EXPENDITURE The ratio of capital expenditure to (lag) net property, plant DataStream item:
and equipment. WC04601, WC02501

R&D A dummy variable indicating whether firms invest in R&D DataStream items:
and 0 otherwise. Firms that do not report R&D expenses are WC01201, WC01001
considered to be firms with no R&D expenses.
MARKET LEVERAGE The ratio of total debt (long term debt plus short term debt) DataStream items:
to total assets minus book value of equity plus market value WC03251, WC03051,
of equity. WC02999, WC03501, MV
MANAGERIAL OWNERSHIP The percentage of shares held by the management and Board Analyst item:
directors, as reported in the company’s most recent proxy InsidersPctg
statement.
MANAGERIAL RISK AVERSION A dummy variable indicating firms that have both high Board Analyst item:
managerial ownership (third tercile of the distribution) InsidersPctg; Datastream
and high idiosyncratic risk (third tercile of the items: RI; French’s Risk
distribution). Factors.

29
ID_RISK(CARHART 4-Factor) The standard deviation of the residual series derived from Datastream items: RI
(%) the Carhart 4-factor model. French’s Risk Factors:
http://mba.tuck.dartmouth
.edu/pages/faculty/ken.fre
nch/data_library.html

ID_RISK(FAMA-FRENCH 5- The standard deviation of the residual series derived from Datastream items: RI
Factor) (%) the Fama-French 5-factor model. French’s Risk Factors:
http://mba.tuck.dartmouth
.edu/pages/faculty/ken.fre
nch/data_library.html
(See Section 3.2 for
details)

IMPLIED VOLATILITY The implied volatility is calculated as an annual average of OptionMetrics: Volatility
30-day, at-the money (ATM) daily implied volatilities. surface files (See Section
5.1.1 for details)

ID_RISK(SKEWNESS) (%) The skewness of the residual series term of Fama-French Datastream items: RI
5-factor model. This is estimated through the formula: French’s Risk Factors:

ID _ RISK  SKEWNESS  
1   it3
t
http://mba.tuck.dartmouth
.edu/pages/faculty/ken.fre
3
T  1 

nch/data_library.html
 2 
t it 
 T 
where T refers to the numbers of weeks in each year
(estimated on a yearly basis using weekly data)

TABLE 1 (continued)
Variable Name Definition Data Items used

DIVIDEND (%) The ratio of total dividends to total assets. DataStream items:
WC18192, WC01701,
WC02999
INVESTMENT (%) The ratio of capital expenditures to total assets. DataStream items:
WC04601, WC02999

CASH HOLDING (%) The ratio of cash holdings to total assets. DataStream items:
WC02001, WC02999

FIRM_SIZE The natural logarithm of the share price multiplied by the DataStream items: MV
number of ordinary shares in issue.

LEVERAGE (FINANCIAL) (%) The ratio of total debt (long term debt plus short term DataStream items:
debt) to total assets. WC03251, WC03051,
WC02999
CASH_FLOW (%) The ratio of earnings after interest, common dividends DataStream items:
and taxes but before depreciation to (lag) net property, WC18198, WC01451,
plant and equipment. WC01251, WC05376,
WC02999
CASH_FLOW_VOLATILITY (%) The standard deviation of the firm’s cash flow over the DataStream items:
prior four-year period. WC18198, WC01451,
WC01251, WC05376,
WC02999

30
SALES Natural log of sales revenue. DataStream item:
WC01001

TANGIBILITY (%) The ratio of net property, plant and equipment to total DataStream item:
assets. WC02501

FIRM_AGE Natural log of the number of years the firm has DataStream item:
DataStream data, calculated as the difference between the WC11516
firm’s fiscal year less the date that the firm was included
in the DataStream dataset (plus one).
TOTAL ASSETS Natural log of book value of total assets. DataStream item:
WC02999
STAGGERED_BOARD (%) A dummy variable indicating a classified board voting Board Analyst item:
structure where directors stand for re-election on a BdClassified
staggered schedule.

OTHER_CEO_DIRECTORS (%) The ratio of the number of directors on a board who are Board Analyst item:
active CEOs of other public or private companies to the DirectorsActiveCEOs,
total number of directors on the board. DirectorsOutsideTotal,
DirectorsInside

NO_ATTEND_DIRECTORS (%) The ratio of the number of directors that have failed to Board Analyst item:
meet the board's minimum attendance standards to the DirectorsFailed,
total number of directors on the board. DirectorsOutsideTotal,
DirectorsInside

Variable Name TABLE 1 (continued) Data Items used

Definition
INDEPENDENT_DIRECTORS (%) The ratio of the number of all fully independent directors Board Analyst item:
on a given board to the total number of directors on the DirectorsOutside,
board. DirectorsOutsideTotal,
DirectorsInside
BUSY_ DIRECTORS (%) The ratio of the number of directors with more than 4 Board Analyst item:
corporate (public) directorships on a given board to the DirectorsOver4Boards,
total number of directors on the board. DirectorsOutsideTotal,
DirectorsInside
EXPERIENCED_ DIRECTORS (%) The ratio of all directors with tenure exceeding 15 years Board Analyst item:
on a given board to the total number of directors on the DirectorsOver15YrsTenur
board. e, DirectorsOutsideTotal,
DirectorsInside
OUTSIDE_ DIRECTORS (%) The ratio of the number of outside directors and the Board Analyst item:
number of outside-related directors to the total number of DirectorsOutsideTotal,
directors on the board. DirectorsInside
OLD_ DIRECTORS (%) The ratio of the number of all directors over the age of 70 Board Analyst item:
on a given board to the total number of directors on the DirectorsOver70,
board. DirectorsOutsideTotal,
DirectorsInside
WOMEN_ DIRECTORS (%) The ratio of the number of all female directors to the total Board Analyst item:
number of directors on the board. DirectorsWomen,
DirectorsOutsideTotal,
DirectorsInside
BOARDSIZE The number of total number of directors on the board. Board Analyst items:
DirectorsOutsideTotal,
DirectorsInside

31
OPTION DELTA/ OPTION VEGA Option delta refers to the dollar change in CEO stock and ExecuComp: See
option portfolio for a 1% change in stock price. Option Milidonis and
vega refers to the dollar change in CEO option holdings Stathopoulos (2014)
for a 1% change in stock return volatility.

TABLE 2
Descriptive Statistics
This table presents analytical descriptive statistics for all variables used in our analysis (where possible,
for the full sample of 1,969 firms/7,295 firm-year observations). Analytical definitions for all variables are
provided in Table 1.
Mean St. Dev. Min 25% Median 75% Max
Firm Value Proxies
TOBIN’S Q 1.88 1.04 0.52 1.22 1.55 2.16 7.98
ENTERPRISE VALUE 2.43 2.76 0.14 0.85 1.55 2.83 16.94
ROA 0.04 0.11 -0.57 0.03 0.06 0.09 0.22
Financial and Investment Policies
CAPITAL EXPENDITURE 0.24 0.19 0.02 0.12 0.19 0.31 1.12
R&D 0.47 0.49 0.00 0.00 0.00 1.00 1.00
MARKET LEVERAGE 0.38 0.49 0.00 0.04 0.19 0.51 1.88
Key Explanatory Variables
MANAGERIAL OWNERSHIP (%) 14.58 15.25 0 3.14 7.90 22.08 64.84
DOLLARMAN (in million $) 320.9 523.7 2.6 38.2 106.1 310.1 2141.4
Idiosyncratic Risk Proxies
ID_RISK(CARHART 4-Factor) (%) 4.55 2.41 0.91 2.93 3.97 5.52 24.49
ID_RISK(FAMA-FRENCH 5-Factor) (%) 4.50 2.37 0.92 2.92 3.93 5.46 25.30
ID_RISK (SKEWNESS) -0.06 0.78 -6.49 -0.41 0.00 0.37 4.09
IMPLIED VOLATILITY (% Annualized) 38.18 14.93 11.36 28.96 35.53 45.05 128.13
Control Variables
DIVIDEND (%) 1.05 1.78 0 0 0.11 1.54 19.31
INVESTMENT (%) 5.29 5.08 0 2.08 3.78 6.63 48.42
CASH HOLDING (%) 16.34 18.84 0 2.52 8.58 23.94 98.99
FIRM_SIZE 7.40 1.55 4.18 6.45 7.40 8.49 11.54
LEVERAGE (FINANCIAL) (%) 22.72 18.55 0 5.03 21.93 34.76 98.82
32
CASH FLOW VOLATILITY (%) 38.55 91.38 0.11 3.02 8.98 29.12 177.81
SALES (log) 14.13 1.59 7.81 13.10 14.08 15.17 17.74
TANGIBILITY (%) 29.25 23.93 0 10.42 21.60 43.59 97.58
FIRM AGE (log) 2.39 0.30 0.69 2.19 2.39 2.56 2.77
TOTAL ASSETS (log) 14.34 1.53 9.60 13.24 14.25 15.31 18.23
STAGGERED_BOARD (%) 96.79 17.62 0 100 100 100 100
OTHER_CEO_DIRECTORS (%) 36.21 27.11 0 16.67 28.57 42.86 100
NO_ATTEND_DIRECTORS (%) 1.41 4.53 0 0 0 0 100
INDEPENDENT_DIRECTORS (%) 69.55 15.48 0 60 71.43 81.82 100
BUSY_ DIRECTORS (%) 9.82 12.23 0 0 7.69 16.67 90
EXPERIENCED_ DIRECTORS (%) 14.99 17.08 0 0 11.11 25 100
OUTSIDE_ DIRECTORS (%) 79.94 11.60 0 75 83.33 88.89 100
OLD_ DIRECTORS (%) 8.99 12.20 0 0 0 14.29 71.43
WOMEN_ DIRECTORS (%) 9.59 9.32 0 0 10 14.29 60.00
BOARDSIZE 8.97 2.31 3 7 9 10 21

33
 TABLE 3
Parametric and Semi-parametric Results for firms with Low and High Idiosyncratic Risk
[ID_RISK(FAMA-FRENCH 5-Factor)]
This table presents evidence on the impact of managerial ownership on Tobin’s Q for low idiosyncratic risk
(Panel A) and high idiosyncratic risk (Panel B) companies. Companies are assigned into each risk group
according to their ID_RISK (FAMA-FRENCH 5-Factor) using the 33rd and 67th percentiles as cut-off points. t-
values are given in parentheses. Analytical definitions of all variables are provided in Table 1. ***, ** and *
indicate that the coefficient is statistically significant at the 1%, 5% and 10% level respectively. GCV stands
for the Generalized Cross-Validation score of each model (see Section 3.3 for details). Wald statistic (p-value)
tests the null hypothesis that both terms of managerial ownership are equal to 0 in the parametric model. F-test
(p-value) contains the p-value corresponding to the F-test for the statistical significance of the non-parametric
(smooth) term of managerial ownership in the semi-parametric model (the null hypothesis is that that the
smooth term is not statistically significant). For our semi-parametric models, the partial impact of managerial
ownership on firm value is depicted in Figure 1 for low idiosyncratic risk firms and in Figure 2 for high
idiosyncratic risk firms.
Panel A: LOW ID_RISK(FF 5-Factor) Panel B: HIGH ID_RISK(FF 5-Factor)
(Low Idiosyncratic Risk Firms) (High Idiosyncratic Risk Firms)

Parametric Semi-parametric Parametric Semi-parametric

MANAGERIAL OWNERSHIP 1.327*** 0.496
Figure

Figure
(3.41) See (1.12)

See
1

2
MANAGERIAL -2.109*** -0.784
OWNERSHIP_SQUARED (-2.97) (-0.99)
10.558*** 8.664*** 6.766*** 7.923***
DIVIDEND
(8.53) (6.79) (3.42) (7.68)
1.995*** 2.173*** 1.275*** 1.046***
INVESTMENT
(5.17) (5.11) (3.22) (2.63)
1.796*** 1.863*** 1.781*** 1.767***
CASH HOLDING
(9.61) (14.70) (12.30) (14.06)
0.318*** 0.299*** 0.237*** 0.260***
FIRM_SIZE
(19.45) (19.50) (13.81) (18.91)
-0.805*** -0.492*** -0.182 -0.554***
LEVERAGE
(-5.68) (-4.28) (-1.60) (-4.76)
0.017 0.160 0.108 -0.039
STAGGERED_BOARD
(0.10) (1.23) (0.97) (-0.30)
-0.053 -0.204*** -0.210*** -0.118*
OTHER_CEO_DIRECTORS
(-0.76) (-2.60) (-2.64) (-1.66)
-0.315 0.238 0.392 -0.002
NO_ATTEND_DIRECTORS
(-0.74) (0.56) (1.04) (-0.006)
0.140 0.022 -0.287* -0.186
INDEPENDENT_DIRECTORS
(0.87) (0.13) (-1.73) (-1.27)
-0.784*** 0.052 -0.179 -0.652***
BUSY_ DIRECTORS
(-6.03) (0.30) (-0.98) (-4.29)
-0.067 -0.044 0.203 0.099
EXPERIENCED_ DIRECTORS
(-0.53) (-0.36) (1.58) (0.89)
0.040 -0.015 0.309 0.277
OUTSIDE_ DIRECTORS
(0.18) (-0.06) (1.15) (1.21)
-0.078 0.103 0.183 0.200
OLD_ DIRECTORS
(-0.45) (0.62) (1.14) (1.28)
-0.262 0.116 0.090 -0.235
WOMEN_ DIRECTORS
(-1.04) (0.50) (0.40) (-1.10)
-0.081*** -0.101*** -0.088*** -0.070***
BOARDSIZE
(-9.23) (-10.01) (-7.93) (-7.30)
-0.161 -0.096 0.459** 0.344*
Intercept
(-0.70) (-0.43) (2.16) (1.65)
Industry Dummies Yes Yes Yes Yes
Observations 2378 2378 2378 2378
R2 Adjusted 37.28% 31.70% 28.50% 30.00%
GCV Score - 0.855 - 0.721
Wald/F-Test (p-value) 0.00 0.00 0.51 0.39

34
 TABLE 4
Parametric and Semi-parametric Results for firms with Positive and Negative Idiosyncratic Skewness
[ID_RISK(SKEWNESS)]
This table presents evidence on the impact of managerial ownership on Tobin’s Q for low idiosyncratic risk
(Panel A) and high idiosyncratic risk (Panel B) companies. Companies are assigned into each risk group
according to their ID_RISK (SKEWNESS) using the 33rd and 67th percentiles as cut-off points. t-values are
given in parentheses. Analytical definitions of all variables are provided in Table 1. ***, ** and * indicate that
the coefficient is statistically significant at the 1%, 5% and 10% level respectively. GCV stands for the
Generalized Cross-Validation score of each model (see Section 3.3 for details). Wald statistic (p-value) tests
the null hypothesis that both terms of managerial ownership are equal to 0 in the parametric model. F-test (p-
value) contains the p-value corresponding to the F-test for the statistical significance of the non-parametric
(smooth) term of managerial ownership in the semi-parametric model (the null hypothesis is that that the
smooth term is not statistically significant). For our semi-parametric models, the partial impact of managerial
ownership on firm value is depicted in Figure 3 for low idiosyncratic risk firms and in Figure 4 for high
idiosyncratic risk firms.
Panel A: Most Positive ID_RISK(SKEWNESS) Panel B: Most Negative ID_RISK(SKEWNESS)
(Low Idiosyncratic Risk Firms) (High Idiosyncratic Risk Firms)

Parametric Semi-parametric Parametric Semi-parametric

MANAGERIAL OWNERSHIP 1.719*** 0.225

Figure

Figure
(4.18) See (0.52)

See
3

4
MANAGERIAL -2.648*** -0.203
OWNERSHIP_SQUARED (-3.60) (-0.25)
8.769*** 8.664*** 7.939*** 7.923***
DIVIDEND
(4.71) (6.79) (5.41) (7.68)
2.269*** 2.173*** 1.050*** 1.046***
INVESTMENT
(4.54) (5.11) (3.19) (2.63)
1.864*** 1.863*** 1.764*** 1.767***
CASH HOLDING
(10.98) (14.70) (11.09) (14.06)
0.293*** 0.299*** 0.260*** 0.260***
FIRM_SIZE
(17.59) (19.50) (16.46) (18.91)
-0.494*** -0.492*** -0.556*** -0.554***
LEVERAGE
(-3.84) (-4.28) (-4.97) (-4.76)
0.166 0.160 -0.042 -0.039
STAGGERED_BOARD
(1.24) (1.23) (-0.29) (-0.30)
-0.215*** -0.204*** -0.119* -0.118*
OTHER_CEO_DIRECTORS
(-2.76) (-2.60) (-1.69) (-1.66)
0.222 0.238 -0.016 -0.002
NO_ATTEND_DIRECTORS
(0.39) (0.56) (-0.04) (-0.00)
0.007 0.022 -0.186 -0.186
INDEPENDENT_DIRECTORS
(0.05) (0.13) (-1.17) (-1.27)
0.050 0.052 -0.650*** -0.652***
BUSY_ DIRECTORS
(0.27) (0.30) (-4.38) (-4.29)
-0.034 -0.044 0.096 0.099
EXPERIENCED_ DIRECTORS
(-0.27) (-0.36) (0.78) (0.89)
-0.007 -0.015 0.291 0.277
OUTSIDE_ DIRECTORS
(-0.03) (-0.06) (1.20) (1.21)
0.121 0.103 0.205 0.200
OLD_ DIRECTORS
(0.72) (0.62) (1.24) (1.28)
0.075 0.116 -0.225 -0.235
WOMEN_ DIRECTORS
(0.30) (0.50) (-0.97) (-1.10)
-0.101*** -0.101*** -0.071*** -0.070***
BOARDSIZE
(-9.50) (-10.01) (-7.35) (-7.30)
0.163 -0.096 0.283 0.344*
Intercept
(0.72) (-0.43) (1.31) (1.65)
Industry Dummies Yes Yes Yes Yes
Observations 2378 2378 2378 2378
R2 Adjusted 32.38% 31.70% 30.71% 30.00%
GCV Score - 0.855 - 0.721
Wald/F-Test (p-value) 0.00 0.00 0.63 0.39

35
 TABLE 5
Parametric and Semi-parametric Results for firms with Low and High Implied Volatility
[ID_RISK(Implied Volatility)]
This table presents evidence on the impact of managerial ownership on Tobin’s Q for low risk (Panel A) and
high risk (Panel B) companies. Companies are assigned into each risk group according to their ID_RISK
(Implied Volatility) using the 33rd and 67th percentiles as cut-off points. t-values are given in parentheses.
Analytical definitions of all variables are provided in Table 1. ***, ** and * indicate that the coefficient is
statistically significant at the 1%, 5% and 10% level respectively. GCV stands for the Generalized Cross-
Validation score of each model (see Section 3.3 for details). Wald statistic (p-value) tests the null hypothesis
that both terms of managerial ownership are equal to 0 in the parametric model. F-test (p-value) contains the p-
value corresponding to the F-test for the statistical significance of the non-parametric (smooth) term of
managerial ownership in the semi-parametric model (the null hypothesis is that that the smooth term is not
statistically significant). For our semi-parametric models, the partial impact of managerial ownership on firm
value is depicted in Figure 5 for low risk firms and in Figure 6 for high risk firms.
Panel A: LOW ID_RISK (IV) Panel B: HIGH ID_RISK (IV)
(Low Risk Firms) (High Risk Firms)

Parametric Semi-parametric Parametric Semi-parametric

MANAGERIAL OWNERSHIP 1.617*** 0.748

Figure

Figure
(3.15) See (1.33)

See
5

6
MANAGERIAL -2.612*** -0.615
OWNERSHIP_SQUARED (-2.73) (-0.62)
12.009*** 11.917*** 5.945** 6.160***
DIVIDEND
(6.30) (8.14) (2.08) (3.19)
3.311*** 3.305*** 1.386*** 1.380**
INVESTMENT
(5.22) (4.42) (2.75) (2.54)
2.346*** 2.347*** 1.518*** 1.521***
CASH HOLDING
(7.77) (10.95) (7.94) (9.69)
0.273*** 0.283*** 0.293*** 0.293***
FIRM_SIZE
(10.56) (12.08) (11.34) (12.23)
-0.744*** -0.742*** -0.421*** -0.418***
LEVERAGE
(-3.51) (-3.87) (-2.82) (-2.73)
-0.097 -0.119 -0.136 -0.132
STAGGERED_BOARD
(-0.37) (-0.56) (-0.83) (-0.82)
0.024 0.036 -0.505*** -0.501***
OTHER_CEO_DIRECTORS
(0.23) (0.35) (-4.77) (-4.61)
-0.696 -0.605 1.464** 1.467***
NO_ATTEND_DIRECTORS
(-1.37) (-1.12) (2.52) (2.64)
0.020 0.042 -0.108 -0.107
INDEPENDENT_DIRECTORS
(0.08) (0.18) (-0.42) (-0.46)
-0.506*** -0.491** 0.208 0.210
BUSY_ DIRECTORS
(-2.71) (-2.42) (0.69) (0.88)
-0.352* -0.377** 0.273* 0.281*
EXPERIENCED_ DIRECTORS
(-1.82) (-2.12) (1.74) (1.76)
0.368 0.340 0.433 0.416
OUTSIDE_ DIRECTORS
(1.02) (0.97) (1.14) (1.28)
0.730** 0.737*** 0.006 0.002
OLD_ DIRECTORS
(2.43) (2.87) (0.03) (0.01)
-0.306 -0.290 0.147 0.151
WOMEN_ DIRECTORS
(-0.87) (-0.85) (0.46) (0.49)
-0.082*** -0.079*** -0.112*** -0.112***
BOARDSIZE
(-6.66) (-6.27) (-7.90) (-7.40)
-0.903** -0.495 -0.135 0.270
Intercept
(-2.57) (-1.59) (-0.41) (0.82)
Industry Dummies Yes Yes Yes Yes
Observations 1271 1271 1271 1271
R2 Adjusted 41.41% 40.30% 32.79% 31.50%
GCV Score - 0.784 - 0.823
Wald/F-Test 0.00 0.01 0.06 0.02

36
 TABLE 6
The Role of Stock Options
This table presents evidence on the impact of managerial ownership on Tobin’s Q for firms that have both a
high level of idiosyncratic risk (third tercile of the ID_RISK (FAMA-FRENCH 5-Factor) distribution) and a
high option delta (above median delta values) (see Panel A) and firms that have both a high level of
idiosyncratic risk (third tercile of the ID_RISK (FAMA-FRENCH 5-Factor) distribution) and a low option delta
(below median delta values) (see Panel B). The estimation is restricted to the period 2001-2006 due to the lack
of options data for other years. Analytical definitions of all variables are provided in Table 1. ***, ** and *
indicate that the coefficient is statistically significant at the 1%, 5% and 10% level respectively. GCV stands
for the Generalized Cross-Validation score of each model (see Section 3.3 for details). Wald statistic (p-value)
tests the null hypothesis that both terms of managerial ownership are equal to 0 in the parametric model. F-test
(p-value) contains the p-value corresponding to the F-test for the statistical significance of the non-parametric
(smooth) term of managerial ownership in the semi-parametric model (the null hypothesis is that that the
smooth term is not statistically significant). For our semi-parametric models, the partial impact of managerial
ownership on firm value is depicted in Figures 7 and 8.
Panel A: HIGH ID_RISK Panel B: HIGH ID_RISK
& HIGH OPTION DELTA & LOW OPTION DELTA
Parametric Semi-parametric Parametric Semi-parametric
MANAGERIAL OWNERSHIP 1.731** 0.007

Figure

Figure
(2.49) See (0.01)

See
7

8
MANAGERIAL -1.743 0.412
OWNERSHIP_SQUARED (-1.47) (0.41)
3.099 3.180 7.831*** 7.768***
DIVIDEND
(0.95) (1.09) (2.93) (3.86)
2.319*** 2.301*** 0.784 0.792
INVESTMENT
(3.36) (3.29) (1.20) (1.55)
1.861*** 1.864*** 1.017*** 1.019***
CASH HOLDING
(7.75) (10.20) (6.29) (7.76)
0.276*** 0.273*** 0.137*** 0.138***
FIRM_SIZE
(8.34) (9.91) (5.92) (5.75)
-0.934*** -0.933*** -0.223 -0.226*
LEVERAGE
(-3.67) (-4.90) (-1.70)* (-1.72)
-0.060 -0.055 0.145 0.144
STAGGERED_BOARD
(-0.40) (-0.38) (1.23) (1.15)
-0.385*** -0.378*** -0.324*** -0.328***
OTHER_CEO_DIRECTORS
(-3.69) (-3.74) (-4.55) (-4.13)
-0.858** -0.852* 0.551 0.539
NO_ATTEND_DIRECTORS
(-2.01) (-1.74) (1.02) (1.20)
-0.349 -0.340 -0.120 -0.115
INDEPENDENT_DIRECTORS
(-1.02) (-1.21) (-0.44) (-0.56)
0.101 0.094 -0.316 -0.307
BUSY_ DIRECTORS
(0.33) (0.30) (-1.54) (-1.29)
0.276 0.278 -0.037 -0.042
EXPERIENCED_ DIRECTORS
(1.58) (1.55) (-0.23) (-0.28)
0.815* 0.799** 0.003 0.008
OUTSIDE_ DIRECTORS
(1.70) (1.99) (0.01) (0.03)
0.126 0.133 0.673*** 0.675***
OLD_ DIRECTORS
(0.54) (0.56) (2.78) (3.10)
0.095 0.094 -0.664** -0.660**
WOMEN_ DIRECTORS
(0.23) (0.25) (-2.33) (-2.53)
-0.091*** -0.091*** -0.061*** -0.061***
BOARDSIZE
(-5.25) (-5.72) (-4.52) (-4.43)
-1.608*** -0.033 0.896*** 0.890***
Intercept
(-4.76) (-0.13) (3.73) (4.42)
Industry Dummies Yes Yes Yes Yes
Observations 1050 1050 1050 1050
R2 Adjusted 34.47% 32.90% 23.33% 21.50%
GCV Score - 0.877 - 0.504
Wald/F-Test (p-values) 0.00 0.00 0.41 0.14

37
 TABLE 7
Evidence From Corporate Policies
This table presents evidence on the impact of managerial risk aversion on four corporate (financial and
investment) policies. The dependent variables are CAPITAL EXPENDITURE, defined as the ratio of capital
expenditure to (lag) net property, plant and equipment; R&D, a dummy variable indicating whether firms invest
in R&D and 0 otherwise. Firms that do not report R&D expenses are considered to be firms with no R&D
expenses; MARKET LEVERAGE, defined as the ratio of total debt (long term debt plus short term debt) to total
assets minus book equity plus market value of equity, and FINANCIAL LEVERAGE, defined as the ratio of
total debt (long term debt plus short term debt) to total assets. Managerial risk aversion is a dummy variable
that equals 1 for firms that have both high managerial ownership (third tercile of the distribution) and high
idiosyncratic risk (third tercile of the distribution) and 0 otherwise. Idiosyncratic risk (ID_RISK) is the standard
deviation of the residual series derived from the Fama-French 5-factor model. Following Fracassi (2017), firm
size is proxied by Total Assets (log) in the investment specification (Model 1) and by Sales (log) in the R&D
and Leverage specifications (Models 2, 3 and 4). We use a logistic regression for estimating Model 2. t-values
are given in parentheses. Analytical definitions of all variables are provided in Table 1. ***, ** and * indicate
that the coefficient is statistically significant at the 1%, 5% and 10% level respectively.

CAPITAL R&D MARKET FINANCIAL

EXPENDITURE LEVERAGE LEVERAGE
(1) (2) (3) (4)

-0.019** -0.443*** -0.038** -0.013**

MANAGERIAL RISK AVERSION
(-2.17) (-4.24) (-2.09) (-2.42)
0.057*** 0.346*** -0.061*** -0.012***
TOBIN’S Q
(14.72) (12.47) (-7.87) (-5.40)
0.007*** -0.113*** -0.009*** -0.002***
CASH FLOW
(7.73) (-7.12) (-4.89) (-3.99)
-0.008 -0.131*** 0.057*** 0.012***
FIRM SIZE
(-1.05) (-6.92) (3.47) (2.61)
- -3.843*** 0.126 0.051*
TANGIBILITY
- (-27.01) (1.42) (1.95)
- 0.075** 0.026*** 0.002
CASH FLOW VOLATILITY
- (2.07) (3.44) (0.93)
- -0.798 0.510 0.614***
DIVIDEND
- (-0.49) (1.31) (5.35)
0.058*** 0.494*** 0.357*** 0.028***
FIRM AGE (log)
(4.94) (5.31) (13.67) (3.67)
0.268*** - - -
CASH HOLDING
(10.71) - - -
0.075 1.100*** -1.186*** -0.011
Intercept
(0.74) (3.59) (-5.79) (-0.18)
Fixed Effects Yes No Yes Yes
Observations 7295 7295 7295 7295
R2 Adjusted [Pseudo- R2] 57.57% [15.09%] 72.94% 83.04%

38
 Figure 1
Semi-parametric estimate: The net effect of
managerial ownership on Tobin’s Q for firms
with low standard deviation of residuals
derived from the Fama-French 5-factor model
(low idiosyncratic risk)
Figure 3
Semi-parametric estimate: The net effect of
managerial ownership on Tobin’s Q for firms with
most positive idiosyncratic skewness of residuals
derived from the Fama-French 5-factor model
(low idiosyncratic risk)
39
Figure 2
Semi-parametric estimate: The net effect of
managerial ownership on Tobin’s Q for firms
with high standard deviation of residuals
derived from the Fama-French 5-factor model
(high idiosyncratic risk)
Figure 4
Semi-parametric estimate: The net effect of
managerial ownership on Tobin’s Q for firms with
most negative idiosyncratic skewness of residuals
derived from the Fama-French 5-factor model
(high idiosyncratic risk)
 Figure 5 Figure 6
Semi-parametric estimate: The net effect of Semi-parametric estimate: The net effect of
managerial ownership on Tobin’s Q for firms with managerial ownership on Tobin’s Q for firms with
low option implied volatility high option implied volatility
(low firm risk) (high firm risk)

Figure 7 Figure 8
Semi-parametric estimate: The net effect of managerial Semi-parametric estimate: The net effect of managerial
ownership on Tobin's Q for firms that combine high ownership on Tobin's Q for firms that combine high
idiosyncratic risk and a high stock option delta. idiosyncratic risk and a low stock option delta.

40