Synthetic repurchase programs through put derivatives: theory and evidence

Abstract

A Synthetic Repurchase is an open market share repurchase program enhanced with sales of put derivatives on the firm’s own stock. Microsoft, in 1999, using a synthetic repurchase program sold put derivatives on its own stock and received $766 million in premiums and, at the same time, signaled that it is a good-quality company and certified its future earnings. I present theoretical rationale that explains why a synthetic repurchase program provides an efficient signal about a firm’s future prospects and how it establishes a separating equilibrium between good and bad firms. I also postulate that the signal provides quality certification about the firms’ future prospect. A sample of all companies that are known to have sold put derivatives was collected by searching 10-K and 10-Q statements published between January 1988 and January 2000. The sample includes the 53 identified companies that have initiated synthetic repurchase programs. I find empirical confirmation of the signaling hypothesis for synthetic repurchases. Event study results empirically confirm the theoretical hypothesis that the initiation of a synthetic repurchase program provides a positive signal to the market. Also, the empirical results confirm the theoretical hypothesis that the termination of a synthetic repurchase program is a negative signal to the market. The market reacts positively to the initiation of a synthetic repurchase program, and negatively to its termination. I also performed an EPS analyst forecast revisions event study with very similar results, which also confirm the signaling hypothesis of asymmetric information.. Results also show a positive and statistically significant 11.7% book-to-market and size-adjusted buy-and-hold abnormal average annual return. In addition, I find a significant improvement in various measures of the financial profiles of the firms in the sample subsequent to the put derivative sale. Finally, I observe that these firms have higher earning, R & D expenditures, and cash flows as compared with two industry-and-size-matched control samples of rival firms with and without repurchase programs respectively. Risky R & D expenditures force a firm to initiate synthetic repurchase programs in order to signal the market about their expectation of good future EBIT figures.%%%%Ph.D., Business and Management – Drexel University, 2001