Employee stock option exercises An empirical analysis.docx
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Employee stock option exercises An empirical analysis.docx
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EmployeestockoptionexercisesAnempiricalanalysis
EmployeeStockOptions:
ExerciseDecisionsByTopExecutives
MarkC.Anderson,TheUniversityofTexasatDallas
Abstract
Thisstudyinvestigatesthetimingofstockoptionexercisedecisionsmadebytopexecutivesat65largecompanies.ExecutivesinthesampletypicallyexercisewhentheintrinsicvalueoftheoptionisapproximatelyequaltoitsBlack-Scholesvalue.SubsequentstockpriceperformanceissignificantlypoorerforexercisedecisionsthataremadewhentheintrinsicvalueismuchlowerthantheBlack-Scholesvalueoftheremainingoptionrights.Thissuggeststhatinterpretationofprivateinformationconveyedbyexercisedecisionsshouldbeconditionedonthecircumstancesoftheexercise.
1.Introduction
Topcorporateexecutivesreceivealargeportionoftheircompensationintheformofstockoptions.Aftervesting,theseoptionsmaybeexercisedattheexecutives’discretion.Twovalue-relevantissuesconcernexercisedecisionsbytopexecutives.First,ifexecutives’exercisedecisionsarepredictablyinfluencedbyriskaversion,theeffectofoptiongrantsontheequityvalueofthefirmmaybelowerthanthemeasuredeffectusingoptionpricingmodelsthatassumerisk-neutralexercisebehavior.Second,ifexecutives’exercisedecisionsarebiasedbyprivateinformation,marketparticipantsmaymakeinferencesaboutfirms’futureprospectsbasedonobservedexercisedecisions.
Inthisstudy,Iprovideadescriptiveanalysisoftheexercisebehavioroftopexecutivesrelativetoabenchmarkexercisepolicy.ThebenchmarkpolicyisbasedontheBlack-Scholes(1973)value(adjustedforanticipateddividends)oftheremainingoptionrightsatthedateofexercise.Ifexecutivesfollowedanexercisepolicyofexercisingwhentheintrinsicvalue(prevailingmarketpriceofthestockminustheexercisepriceoftheoption)andtheBlack-Scholesvaluewereapproximatelythesame,theirexercisedecisionscouldbecharacterizedasrisk-neutralandfreefrominformationbias.Theywouldberisk-neutralbecausetheBlack-Scholesvalueisbasedonrisk-neutraloptionpricingandtheywouldbefreefrominformationbiasbecausetheBlack-Scholesmodelusespubliclyobservableinputs.Therefore,aratiooftheintrinsicvaluetotheBlack-Scholesvalueofoneprovidesaconvenientbenchmarkforevaluatingoptionexercisedecisions.
Forasampleofexercisedecisionsmadebytopexecutivesat65largecompaniesin1992and1993,IfindthatthedistributionoftheratiooftheintrinsicvaluetotheBlack-Scholesvalueiscenteredatone(median=0.996,mean=0.974andstandarddeviation=0.172).Thisindicatesthatthebenchmarkexercisepolicy(exercisingwhentheBlack-Scholesvalueisequaltotheintrinsicvalue)isreasonablydescriptiveoftheexercisebehaviorofthetopexecutivesinthesample.Thissuggeststhattheexecutives’exercisedecisionswerenotlargelyinfluencedbyriskaversionorbyinformationbiases.
Aninterestingquestioniswhetherornotinformationbiasesmaybedetectedforthesubsetsofexercisedecisionsthatvaryconsiderablyfromthebenchmarkpolicy.Toaddressthisquestion,IdividethesampleintogroupsaccordingtotheobservedratiooftheintrinsicvaluetotheBlack-Scholesvalue(theIV/BSratio).IcomparethesubsequentstockpriceperformanceoffirmsinlowandhighIV/BSratiogroupswiththestockpriceperformanceoffirmsinthemiddlegroup(IV/BSratiosaroundone).IfindthatfirmsinthelowIV/BSgroupexhibitsignificantlypoorersubsequentstockpriceperformancethanfirmsinthemiddlegroup.Thissuggeststhat,conditionedonthetimingofexerciserelativetorisk-neutralexercise,value-relevantinformationmaybeconveyedbyexercisedecisionsbytopexecutives.
Theremainderofthispaperisorganizedasfollows.PreviousliteratureaboutthetimingofexercisedecisionsandinsidertradingisreviewedinsectionII.AdescriptionofthesampleandthedataisprovidedinsectionIII.ResultsoftheempiricalanalysisarepresentedinsectionIVandimplicationsofthisresearcharediscussedinsectionV.
2.PreviousLiterature
Inthissection,Iprovideanoverviewofliteratureonthetimingofexercisedecisionsandliteratureonstockpricemovementssubsequenttothesaleofsharesorexerciseofoptionsbyinsiders.
1.ExerciseTiming
Huddart(1994)andKulatilakaandMarcus(1994)userationalutility-maximizingmodelstoshowthat,ifexecutivesadoptrisk-averseexercisepolicies,theeffectofemployeestockoption(ESO)grantsonfirmvalueislowerthanthemeasuredvaluesprovidedbyrisk-neutraloptionpricingmodels.
HuddartandLang(1996)examinedexercisedecisionsofover50,000employeesateightlargecorporations.Theyrelatedtheproportionofaspecificgrantexercisedinamonthtovariousfactorsexpectedtoinfluencethetimingofexercisedecisions.Formostemployees,thevolatilityofstockreturns(basedondailystockreturnsfortheyearpriortotheexercisemonth)hadasignificantinfluenceonthetimingofexercisedecisions.However,forthetopemployees(thosewhorankinthetopfivepercentintermsofnumbersofoptionsreceived),theyfoundthatthevolatilityofstockreturnshadnosignificantinfluenceonthetimingofexercisedecisions.Thisindicatesthatexercisedecisionsbytop-levelemployeesarelesssusceptibletoriskinfluencesthanexercisedecisionsbyemployeesatotherlevels.
Carpenter(1997)directedherattentionspecificallytotopexecutives.ShemotivatedthisemphasisbyobservingthatalargeportionofallstockoptionsgototopexecutivesandthatstockholdersareconcernedaboutmeasuringthevalueoftotalcompensationawardedtoCEOsandothertopexecutives.Carpenterquestionedwhetherexercisedecisionsbytopexecutiveswouldbesignificantlyinfluencedbyriskpreferences.Shereasonedthattopexecutiveshavesufficientwealthtotakepositionsinothersecuritiesthatwouldoffsettheriskassociatedwithoptionsintheirownfirm(forexample,shortpositionsinotherfirmsinthesameindustry).Carpenterconsideredboththeinfluencesofhedgingrestrictions(riskaversion)andemployeeturnover.Shecomparedarationalutility-maximizingmodelthatincorporateshedgingrestrictionsandanendogenousdeparturedecisionwithanaïvevalue-maximizingmodelthathasanexogenousdeparturerate.Sheusedthemodelstoprojectexercisepatternsovertime.Thenshecomparedtheprojectedpatternswithactualexercisepatternsofexecutivesfromabout40firms.Shefoundthatthenaïvemodel(withdeparturerates)providedjustasgoodadescriptionoftheactualexercisedecisionsastherationalutility-maximizingmodel(withdeparturerates).
Resultsoftheseempiricalstudiessuggestthatexercisedecisionsbytopexecutivesarenotlargelyinfluencedbyriskaversion.Inthepresentstudy,Iprovideadescriptionoftheexercisebehavioroftopexecutivesbyrelatingobservedexercisedecisionstoabenchmarkexercisepolicythatusesrisk-neutralpricingoftheremainingoptionrights.
2.InsiderTrading
Studiesofstockpriceperformancesubsequenttoinsidertrading(LorieandNiederhoffer1968;Jaffe1974;Seyhun1986,andSeyhun1992)havefoundpositivestockperformanceafterinsiderpurchasesandnegativestockpriceperformanceafterinsidersales.Seyhun,forexample,findspositiveaverageabnormalreturnsof43basispointspermonthinthesixmonthsafterabuymonthandnegativeaverageabnormalreturnsof88basispointspermonthinthesixmonthsafterasellmonth.Veryfewstudieshaveexaminedstockperformancesurroundingexercisedecisions.ThismaybeduetoatradingrestrictionimposedonoptionexercisesbeforeMay1991.PriortoMay1991,executiveswererequiredtoholdsharesobtainedbyexercisingoptionsforasix-monthperiodbeforetheycouldsellthem.
Inarecentstudy,CarpenterandRenner(1998)usealargedatabaseofexercisedecisionsandprovideanextensiveanalysisofstockpricemovementsbeforeandafteroptionexercisedecisions.Toevaluatestockpriceperformance,CarpenterandRennerdonotmeasureabnormalreturnsusingthemarketmodelapproachevaluatedbyBrownandWarner(1980and1985).Theyobservethatmarketmodelestimateswouldbebiasedbecauseofthelargerun-upinstockpricesbeforeoptionexercise.
CarpenterandRennerfindstrongevidenceofpricerun-upsbeforeoptionexercisebutnoevidenceofnegativestockpriceperformanceafteroptionexercisedecisionsinthecurrent(afterMay1991)regulatoryregime.Aspartoftheiranalysis,theypartitionoptionexercisedecisionsbasedontheratioofthemarketpriceofthestockattheexercisedatetotheexercisepriceoftheoption(themarket-to-strikeratio).Thispartitioningisbasedonthepremisethatlowermarket-to-strikeratioswouldindicatelessincentivetotradefornon-informationreasons.Theydonotfindsignificantdifferencesinsubsequentstockperformanceforthemarket-to-strikegroups.
Theuseofthemarket-to-strikeratioforpartitioningmaynotadequatelyseparateexercisedecisionsbasedontheincentivestotradefornon-informationpurposes.Anticipateddividendpaymentsinfluencethemarket-to-strikeratioatwhichrisk-neutralexerciseoccurs(Merton1973).Otherparameterssuchasthestockreturnvolatilityalsoaffectthemarket-to-strikeratioatwhichrisk-neutralexerciseoccurs.Inaddition,exercisemayoccurbecauseemployeesleavethefirm(andarerequiredtoexercisevestedoptions)orbecausetheoptiontermhasexpired.Inthepresentstudy,IusetheIV/BSratiotoseparateexercisedecisionsintogroups.Thisratiotakesintoconsiderationtheinfluenceofdividendsandotherparametersonthetimin
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