Future Firm Risks and Managers’ Personal Portfolio Decisions

Abstract

Managers often have foreknowledge of events that can increase future firm risks. In this study, I examine whether managers alter their personal portfolios based on their foreknowledge. Specifically, I examine whether managers expedite or delay their stock option exercises in anticipation of increases in future stock-return volatility. The answer is not immediately obvious. On one hand, increases in future volatility may increase the value of stock options, which might motivate managers to delay their option exercises. On the other hand, higher volatility also increases the likelihood of large declines in options’ in-the-money values, risks that managers cannot easily hedge or diversify. This might motivate risk-averse managers to exercise their stock options early and invest the proceeds in less risky assets. I find that managers holding deep in-the-money options expedite their option exercises when they anticipate increases in future stock-return volatility. My study identifies a setting in which managers align their personal holdings to future firm risks, rather than align future firm risks to their personal risk appetites. I argue that the former may be beneficial to shareholders even though managers exploit their informational advantages in making their personal decisions.

Keywords: Firm risks, Management compensation, Stock options, Personal portfolios, Agency theory

JEL Classification: G14, J33, M12