stockholder can reduce agency cost by involving in option trading. He can also headge his risk by takhing both (short and long) positions at the same time. His market risk will be diversified. His return will increase and he will earn relatively high than his earning in agency activities...

I imagine that you are referring to employee stock options, and that agency activities here refer to those  explicit and implicit  activities of managers and their associated cost. Then the following theoretical implications are suggested:

1. Less conflict with respect to shared value and overall enterprise objective, i.e. key objective will then be shareholders' wealth maximization, as managers see themselves as principals rather than agents.

2. Shareholder-manager will be disposed to pay more dividend than agent-manager.

3. Management under this condition is likely to assume greater financial risk by increasing its financial leverage (e.g. Increasing the debt/equity ratio), and take advantage of cheaper and tax deductible interest costs. Theoretically, (though arguably) this increases the market value of the enterprise. 

4. Another implication is that, with employee stock option, shareholder-manager is now favorably disposed to projects with longer life whose acceptance is determined by discounted cash flow techniques. This method increases the wealth of shareholders by increasing the MV of the stock. 

  Generally, this phenomenon suggests that shareholder-manager will only take decisions that aim to increase the share price of the enterprise such as in financing, investing, dividend and liquidity decisions. 

Hi Jian

I think Mr. Daibi Dagogo did a good job on explaining the main motivations for why, theoretically, an employed manager, who owns stock options in the company he manages, will be less prone to at least some types of problematic agency behavior.

I think it worthwhile to elaborate a bit on Dagogo's point 3, the paranthesis in fact. There is one problem with many stock options, and that is that they are often timelimited in some form. Fx they can be realised only after some time T1 and before some other time T2. We have seen, that his may in fact cause agency problems in terms of risk and time horizon: The manager may be looking specifically for investment options, which will increase volume or potential earnings in the window where he/she can exercise his/her stock options - and ignore risks and possible costs associated with the investments that are further out in the future. When he/she has harvested the gains, switching jobs before problems arise is a viable option - especially with an apparently succesful back dropping. 

In my country, we saw this kind of problems in medium and small banks, where boards were not professional enough to see the problem. For that reason, we see a practice now, where managers are forced (by company owners, e.g. capital funds) to buy a significant (for an individual person) position of actual stocks in companies they are hired to lead, and then put restrictions on when and how these can be sold.

The point is to force the long-term objectives onto the manager in question.

cheers

Bo

Dear Liu,

The theoretical implications were very well explained by Mr. Dagogo and Thorsen.

I am investigating the behavior of earnings and the exercise of options in Brazil. Studies indicate an increase in earnings before the exercise of options and after that a reversal, as commented Mr. Thorsen. Evidence of this can be seen in: http://aaajournals.org/doi/abs/10.2308/accr.2004.79.4.889.

Good reading.