Are Executive Stock Option Exercises Driven by Private Information?

Abstract

We examine the extent to which executive stock option exercises may be driven by private information. Contrary to the maintained assumption in prior literature that all shares acquired though exercises are immediately sold, we found that no shares are sold within thirty days following approximately half of the exercises. Generally speaking, we find strong evidence that executives are exploiting positive private information when they exercise the options but hold the shares beyond thirty days, and weaker evidence that they are exploiting negative private information when they exercise the options and sell the shares within thirty days. To increase the power of tests, especially on the negative side, we consider several factors that may be important to executives when making exercise decisions. Along with the exploitation of private information, these include dividend and tax incentives to exercise early, opportunity costs of early exercise due to the loss of time value in options, and reduction of diversifiable risk and concomitant disguise in potential law suits offered by claims of diversification when options are deeply in the money. We find strong evidence that executive's trading gains are positively correlated with time value and depth. Further findings support the conclusion that executives exploit positive private information by holding options as well as by exercising options and holding the shares.