The Early Exercise of Executive Stock Options and Firms’ Future Systematic and Idiosyncratic Risks

Abstract

Why managers exercise their stock options much earlier than the options’ expiration dates remains an empirical question. I examine whether managers’ early option exercises are related to their private information on future risks, because managers cannot hedge their risk exposure by shorting firm securities. I find that the earliness of managers’ option exercises increases with anticipated future risks. Risks managers face are comprised of market-related and firm-specific components. Managers can relatively easily reduce their market-risk exposure (but not the firm-specific risk exposure) by altering the market exposure of their non-firm holdings’ or by selling index options. Consistently, I find that holding total risk constant, the earliness of managers’ option exercises increases (decreases) with the proportion of total risk that is firm specific (market related). Managers, nevertheless, can hedge their total risk, and thus, also its firm-specific component, albeit by costly mechanisms, such as by private arrangements with banks and by selling call options on firm securities. Managers’ disutility from the idiosyncratic risk component should, thus, reduce with ease with which they can hedge their total risks. Consistently, I find that the incremental earliness of option exercises due to the firm-specific component of risk decreases with liquidity of exchange traded options on firm securities. I believe that this is the first empirical study to show that future risk is an important determinant of managers’ early exercise decisions, and that the effects of systematic and firm-specific risks on managers’ subjective valuation of stock options are not only opposite of each other, but also in their effects on firms’ stock prices. Moreover, I find that a greater liquidity of exchange traded options on firm securities reduces managers’ aversion to holding stock options for longer periods, thereby altering the effectiveness of executive compensation plans.

Keywords: Stock options, Executive compensation, Options exercises, Subjective valuation, Agency theory, Volatility, Beta, Systematic risk, Idiosyncratic risk

JEL Classification: G14, G34, J31, J33, M41, M52