Abstract
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.
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Notes
Scholes et al. (2005) summarize this thinking well in their popular textbook (Chapter 8): “if the employee expects—and this is the key assumption that we cannot overemphasize—the price of the stock to continue to rise through the option maturity date or to some point prior to maturity, early exercise of an NQO (non-qualified stock options) and holding the stock until sale date can be tax favored. Early exercise can be tax-favored because more of the total gain is taxed at lower capital gains rates than ordinary rates.”
There are actually 105,000 exercise observations. However, options that have the same exercise price and expiration date but are classified as independent exercises because they have different vesting date, are considered as one observation.
As well, executives may prefer non-option compensation in such periods.
We thank Steve Huddart for providing the algorithm used in their study.
Before the 2002 Sarbanes-Oxley act, corporate insiders were required to report their transactions by the 10th day of the following month. The act reduced the reporting delay to two business days.
As will be discussed later, to verify whether our results are robust under alternative risk adjustments, we also conduct risk adjustment using the four-factor Fama-French model.
To make sure that a company has options, we use option grant data and option holding data reported in SEC form 3, 4 and 5. For option grants, we first collect all option grant data and select the time for the earliest option grant for each firm. We assume that the company has executive options outstanding after this date.
In analysis not reported here, we also look at a sub-sample with partial sale of shares. The abnormal returns observed are between the sell-all or keep-all sample. This result is available upon request.
Reducing the time frame from 30 days to five business days yields qualitatively similar results.
During our sample period gains to employee stock options were taxed as ordinary income and stock capital appreciation where stock is held for more than 1 year was taxed at a lower capital gains rate.
The factor returns are obtained from Ken French’s website.
The independent variable is ranked from 0 to 4 in pooled population.
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Aboody, D., Hughes, J., Liu, J. et al. Are executive stock option exercises driven by private information?. Rev Account Stud 13, 551–570 (2008). https://doi.org/10.1007/s11142-007-9050-3
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DOI: https://doi.org/10.1007/s11142-007-9050-3