Insiders versus Outsiders with Employee Stock Options: Who Knows Best About Future Firm Risk and Implications for Stock Returns
26 Pages Posted: 19 Feb 2007
Date Written: February 15, 2007
Executive stock options (ESOs) have been extensively examined. An unexplored but highly relevant issue is how the options are valued and what information this valuation provides to the market. Understanding ESOs valuation is difficult because there is no set method. Using a model such as Black-Scholes requires an input for volatility that is the firm's best guess of its future risk. We explore two hypotheses about this volatility measure. First, we compare it to past realized volatility to see if insiders have better information about the firm's future risk, and we find that they do. Second, we examine if insider forecasts of future firm volatility relative to past volatility affects future stock returns. We expect that if risk is expected to decrease (increase) then future stock returns will be higher (lower) than otherwise. Our results support this hypothesis. This suggests that insiders can forecast future risk changes, and this risk change affects returns.
Keywords: Employee Stock Options, Black-Scholes, Volatility, Firm Risk
JEL Classification: G14, G32, G35
Suggested Citation: Suggested Citation