The Option to Repurchase Stock

Abstract

Companies often announce their intention to re-acquire shares via open market transactions. These programs are not firm commitments. By design, they provide managers the flexibility to forego repurchasing stock. Managers concerned with maximizing the wealth of long-term stockholders will tend to engage these programs when they view their shares as undervalued and not repurchase shares otherwise. We model this inherent flexibility as an exchange option whereby the market price of the stock is exchanged for the true value of the stock. Using 892 programs announced in the U.S. between 1980 and 1990, the mean market reaction is 3.42%. To the degree that stock prices deviate from fundamental value from time to time, the magnitude of the typical market reaction would appear to be comparable with that suggested by the model. Moreover, as predicted by the model, announcement returns are positively related to the magnitude of the repurchase and to the return volatility of the stock. Perhaps most interestingly, we also find, as suggested by the model, that announcement returns are negatively related to a proxy for the correlation between the firm's traded price and its "true" price, the difference of which is most fundamental to giving value to the option.

JEL Classification: G13