Executive Stock Option Exercise, Insider Trading, and Abnormal Stock Returns

Abstract

This article examines actual executive stock option exercises to investigate corporate insider's use of private information in their decision to exercise stock options. In the year following exercise we document negative cumulative abnormal return of approximately 11%. To distinguish which cohort of insiders are most informed we disaggregate our sample according to six factors: 1) whether the executive exercised prior to maturity, 2) whether the exercise occurred near the vesting date, 3) whether the exercise was dividend related, 4) whether the exercise was induced by departure, 5) the proportion of vested options exercised and 6) the proportion of stock acquired from exercise sold. We find that the most informed insiders are those that exercise early, exercise after the vesting date, exercise a large proportion of vested options, or sell a large proportion of the stock acquired from exercise. It is also shown for dividend paying firms that executives often exercise early just prior to dividend payments; these exercises are non-informative. The purpose of this article is to investigate empirically, whether corporate insiders use private information in their decision to exercise executive stock options. We define private information as the ability to effectively time option exercise and do not allege that it necessarily involves illegal activity on the part of the executive. First, we investigate the information revealed in the exercise pattern of insiders as a whole by examining all insider exercises reported to the SEC from 1996 to 2002. Evidence suggests that insiders do effectively time their exercise. Second, we disaggregate these insiders according to various measures to distinguish which cohort of these insiders are most informed. The results of this study have significant implications for valuation of executive stock options and on hedging procedures of firms that issue executive stock options. It is important to accurately assess the cost of the options to shareholders. If executives are effectively timing the market and expropriating shareholder wealth, then these executive stock options are more expensive to the firm than initially expected. If they are not effectively timing the market, incentive based compensation may be cheaper than initially expected and compensation committees should take this non-informed exercise pattern into consideration.