The Impact of Risk on the Decision to Exercise an ESO

Kyriacos Kyriacou

Economics and Finance Discussion Papers from Economics and Finance Section, School of Social Sciences, Brunel University

Abstract: This paper examines the impact of firms’ risk on executives’ decisions to exercise their executive stock options (ESOs). As the proportion of executives’ remuneration linked to the value of their firm (and therefore shareholder wealth) has increased, so the extent to which these executives hold undiversified personal portfolios has also increased. This lack of personal diversification gives executives a strong incentive to exercise early. It has been shown that this incentive can be sufficiently strong to outweigh the beliefs an executive may have regarding the firm’s valuation. I hypothesise that as the risk of a firm increases, so an ESO exercise is less likely to be induced by an executive’s private information. Consistent with the need to diversify, I find that it is only exercises in low risk firms that precede significantly negative abnormal returns.

Pages: 27 pages
Date: 2003-05
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