Executive Stock Option Exercises Research Articles

Executive Stock Option Exercise with Full and Partial Information on a Drift Change Point

We analyze the optimal exercise of an American call executive stock option (ESO) written on a stock whose drift parameter falls to a lower value at a change point, an exponentially distributed random time independent of the Brownian motion driving the stock. Two agents, who do not trade the stock, have differing information on the change point and seek to optimally exercise the option by maximizing its discounted payoff under the physical measure. The first agent has full information and observes the change point. The second agent has partial information and filters the change point from price observations. This scenario is designed to mimic the positions of two employees of varying seniority, a fully informed executive and a partially informed less senior employee, each of whom receives an ESO. The partial information scenario yields a model under the observation filtration $\widehat{\mathbb{F}}$ in which the stock drift becomes a diffusion driven by the innovations process, an $\widehat{\mathbb{F}}$-Brownian motion also driving the stock under $\widehat{\mathbb{F}}$, and the partial information optimal stopping value function has two spatial dimensions. We rigorously characterize the free boundary PDEs for both agents, establish shape and regularity properties of the associated optimal exercise boundaries, and prove the smooth pasting property in both information scenarios, exploiting some stochastic flow ideas to do so in the partial information case. We develop finite difference algorithms to numerically solve both agents' exercise and valuation problems and illustrate that the additional information of the fully informed agent can result in exercise patterns which exploit the information on the change point, lending credence to empirical studies which suggest that privileged information of bad news is a factor leading to early exercise of ESOs prior to poor stock price performance.

Sarbanes–Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures

Sarbanes–Oxley Act and Patterns in Stock Returns around Executive Stock Option Exercise Disclosures

Sarbanes–Oxley Act and patterns in stock returns around executive stock option exercise disclosures

AbstractWe document negative stock returns and elevated trading volumes around executives’ early option exercise disclosures post‐SOX, but not pre‐SOX. This stock price reaction is incomplete, and the negative stock price drift is smaller post‐SOX compared to pre‐SOX. We also show effects of media coverage in the stock price response to exercise disclosures in the post‐SOX period. These findings provide evidence that the requirement mandated by SOX to disclose executives’ stock option exercises within two business days, and the increased media coverage, improves investors’ ability to incorporate into stock prices in a timely fashion the information conveyed by these exercises.

Class action lawsuits and executive stock option exercise

In a large sample of shareholder initiated class action lawsuits from 1996 to 2011, we find a significant increase in informed insider option exercises during the class action period compared to the preceding quarter, and we find that this change is positively related to the probability of litigation. The market reaction to the announcement of lawsuits is negatively related to abnormal informed option exercises, but positively related to suits that ultimately get dismissed. These results suggest that the market can at least partially anticipate the merits and severity of the class action suit. In subsequent analyses, we find that CEO turnover is positively related to litigation, but not option exercises. Collectively, our results indicate that insiders knowingly trade on their private information.

CEO compensation and timing of Executive Stock Option exercises

This study examines the relationship between Executive Stock Option (ESO) exercise and firm performance in Malaysia for the period 2002-2008. We found a significant positive relationship between ESO exercise and firm performance for both market and accounting-based performance measures using data on ESO exercising from 201 non-financial companies. Our panel data analysis of fixed effect estimation indicated that Malaysian executives are most likely to exercise their options immediately after they are granted; suggesting intended behaviour of adopting ESOs rather than maximising the shareholders' wealth as governance mechanism. This early exercise pattern of Malaysian executives also indicates that executives are averse to the risk.

DO INSIDERS PRACTICE WHAT THEY PREACH? INFORMED OPTION EXERCISES AROUND MERGERS AND ACQUISITIONS

AbstractWe examine executive stock option exercises around a sample of merger and acquisition announcements between 1996 and 2006, focusing on a subset we identify as potentially informed. For stock‐financed acquisitions, we find a surge in informed exercises by acquirer insiders in the year leading up to the acquisition announcement, but target insiders display no similar increase. We find the market reaction upon the announcement for acquirers is negatively related to extreme early exercises and find some evidence of long‐run underperformance. Overall, our evidence indicates that insiders knowingly bid for firms when they personally believe their own firm is overvalued.

Relationship between Executive Stock Option Exercises and Earnings Management*

In this study we examine whether executives manage accounting earnings to maximize their own gains around stock option exercises. In particular, this study analyzes the effects of two factors, the value of exercised executive stock options and the change in the value of exercised executive stock options for a 1% change in the underlying stock price on the propensity of managers to engage in earnings management. Furthermore, the present paper investigates whether the relations between both the value and the price incentive of exercised stock options and earnings management are more affected by the level of information asymmetry and the length of the stock disposition period after exercising stock options. The sample for this study consists of 93 observations from 51 companies listed on the Korea Stock Exchange and Korean Securities Dealers Automated Quotations. Managers exercised their stock options from the fourth quarter of 2002 to the fourth quarter of 2005. The empirical findings are as follows. First, higher values and price incentives for executive stock options were associated with higher earnings management. These results imply that executives manage firms’ reported earnings to maximize their own gains around stock option exercises. Second, information asymmetry reinforces the association between both the values and price incentives of exercised executive stock options and earnings management. Finally, the values and price incentives of exercised executive stock options provide greater incentives for executives to manage earnings when executives sell the acquired stocks after exercising the stock options.

Decomposing Executive Stock Option Exercises: Relative Information and Incentives to Manage Earnings

Abstract: This paper examines the information content of stock option exercises versus regular insider share trades by corporate executives. We argue that the asymmetric payoff structure of options makes managerial wealth – compared to holdings of shares – relatively more sensitive to stock price changes and more likely induces opportunistic behaviour. Consistent with our predictions, we find option exercises followed by share liquidations are associated with disappointing future earnings news, while sales of previously held shares are not. In addition, liquidation exercises of deep in‐the‐money options are associated with larger income‐increasing abnormal accruals, signalling lower quality earnings. On the buy side, we find that regular insider share purchases are associated with positive future earnings news while purchases through option conversions are not. This research has implications for investors, compensation committees, and future research on corporate insider trades.

Executive Stock Option Exercise and Seasoned Equity Offerings

We examine executive stock option exercises around a sample of 1,268 seasoned equity offerings (SEOs) from 1996 to 2004 focusing on a subset of exercises we identify as potentially informed. Consistent with the theory that firms issue equity when stock is overvalued, we document a surge in informed exercise in the months surrounding the SEO. From six months prior to the announcement date to six months after issuance, an average 1.76% of the total market capitalization for issuing firms is exercised and sold. Interestingly, we find a positive association between informed option exercises and long‐run performance. Overall, our collective evidence indicates that insiders are not particularly good at timing exercises around SEOs.

The Manipulation of Executive Stock Option Exercise Strategies: Information Timing and Backdating

ABSTRACTI identify three option exercise strategies executives engage in, including (i) exercising with cash and immediately selling the shares, (ii) exercising with cash and holding the shares, and (iii) delivering some shares to the company to cover the exercise costs and holding the remaining shares. Stock price patterns suggest executives manipulate option exercises. They use private information to increase the profitability of all three strategies, and likely backdated some exercise dates in the pre‐Sarbanes‐Oxley period to enhance the profitability of the latter two strategies, where the executive's company is the only counterparty. Backdating is associated with reporting of internal control weaknesses.

Do Insiders Practice What They Preach? Informed Option Exercises Around Acquisitions

We examine executive stock option exercise activity around a sample of acquisition announcements between 1996 and 2006, particularly focusing on a subset of exercises that we identify as potentially informed. For stock-financed acquisitions, we find a surge in informed exercises by acquirers' insiders in the year leading up to the acquisition announcement and significantly more option exercises when matched to control firms. On the other hand, target insiders display no increase in informed option exercises in the year preceding the merger announcement and significantly less ESO exercises compared to their matched firms. We find the market reaction upon the announcement for acquirers is negatively related to extreme early exercises and the dollar amount of such informed exercises. Firms with informed exercises underperform control-matched firms both from an operating and stock performance perspective. Overall, our evidence indicates that insiders knowingly bid for firms when they personally believe their own firm is overvalued, consistent with the theoretical predictions in Shleifer and Vishny (2003).

Are executive stock option exercises driven by private information?

In this study, we investigate the extent to which exercise of executive stock options is based upon private information. Contrary to popular belief, we find that shares are held more than 30 days following over a quarter of options exercised. Partitioning the data, we find weak evidence that decisions to exercise and sell immediately are prompted by bad news and stronger evidence that decisions to exercise and hold for at least 30 days are prompted by good news. Enhancing the power of our tests by considering several factors important to exercise decisions, we find that the higher the opportunity costs of early exercise as measured by the time-value of options, the greater the trading profits to executives. We also find that the greater the disguise provided by incentives to diversify and consume as measured by the depth of options in the money, the greater the trading profits to executives who exercise and sell. Turning to non-exercise decisions, we find that a strategy of holding options rather than shares to exploit good news yields positive abnormal returns consistent with theoretical predictions in the absence of dividends.

Strategic Timing and Backdating of Executive Stock Option Exercises: Before and After the Sarbanes-Oxley Act

This paper considers executive stock option exercise timing in light of the potential for backdating of exercise dates. I find that 29 (16) percent of executive option exercises were not associated with same-day disposition of shares before (after) the August 29, 2002, enactment of more restrictive SEC reporting requirements for insider transactions under the Sarbanes-Oxley Act. I interpret this as evidence executives often exercise options with the intention of holding the acquired shares for at least a year in order to qualify for long-term capital gains tax treatment on stock appreciation beyond the exercise date. Exercises accompanied by stock disposition are associated with a stock return peak, and exercises not accompanied by stock disposition are associated with a stock return trough. Further tests indicate that in the pre-Sarbanes-Oxley period executives timed exercises ex ante based on private information regardless of the stock disposition strategy, and they often backdated exercise dates when they held the acquired shares or disposed of shares back to the company only. In the post-Sarbanes-Oxley period, executives appear to have benefited through ex ante information timing only.

Executive Stock Option Exercises: Good Timing or Backdating?

Using a large sample of executive stock option exercises by the CEOs of U.S. firms during 1997-2005, I identify three popular exercise mechanisms with different backdating incentives. A cash exercise offers an incentive to exercise at a lower stock price, a stock exercise offers an incentive to exercise at a higher stock price, and a cashless exercise offers little opportunity for backdating. Given the different directions of incentive effects, it becomes critical to separate the three types of option exercises. Empirical results show that for cash exercises the average abnormal stock return is significantly negative before the reported exercise date and significantly positive afterwards. In contrast, stock exercises have the opposite stock return pattern. The market return follows similar but weaker patterns. I estimate that prior to the Sarbanes-Oxley Act (SOX) around one out of eight cash exercises and one out of twenty stock exercises were backdated or otherwise manipulated. Finally, all return patterns become weaker after SOX shortens the reporting period.

Are Executive Stock Option Exercises Driven by Private Information?

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.

EXECUTIVE STOCK OPTION EXERCISES, TAX, AND THE PREDICTIVE ABILITY OF TRANSACTION VALUE

This paper investigates the impact of the tax regime on the predictive ability of UK executives' stock option exercises by categorizing all exercises by the value of the transaction. We use two measures, the net transaction value (which incorporates the cost to the executive of exercising the option, together with the income generated by the associated sale of stock at the time of exercise) and the value of the exercise (which is simply the cost of exercising the option). We show that, in contrast to the existing literature, executive stock option exercises do have predictive ability for future stock returns. This predictive ability relates to transactions that generate net revenue for the executive, a finding that is the reverse of the evidence relating to standard executive transactions, and consistent with a tax motive for executives' exercise behavior.

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

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.

Private Information, Earnings Manipulations, and Executive Stock Option Exercises

This paper investigates the decision by top-level executives of more than 1,200 public corporations to exercise large stock option awards in the period 1992-2001. We hypothesize and find that abnormally large option exercises predict stock return future performance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointing earnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

Private Information, Earnings Manipulations, and Executive Stock-Option Exercises

This paper investigates the decision by top-level executives of more than 1,200 public corporations to exercise a large number of stock option awards in the period 1992–2001. We hypothesize and find that abnormally large option exercises predict stock return future performance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointing earnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

Executive Stock Option Exercises and Inside Information

This article examines whether insiders use private information to time the exercises of their executive stock options. Before May 1991, insiders had to hold the stock acquired through option exercise for 6 months. Exercises from that regime precede significantly positive abnormal stock performance, suggesting the use of inside information to time exercises. By contrast, we find little evidence of such timing since insiders have been able to sell acquired shares immediately. Now, such timing should show up as negative abnormal stock returns after option exercise. However, we find negative stock performance only after exercises by top managers at small firms.