The influence of risk diversification on the early exercise of employee stock options by executive officers

JOURNALOF

ELSEVIER

Journal of Accounting and Economics 21 (1996) 45-68

Accounting &Economids

The influence of risk diversification on the early exercise of employee stock options by executive officers T h o m a s H e m m e r a, Steve M a t s u n a g a *'b, Terry Shevlin c aGraduate School of Business, University of Chicago, Chicago, IL 60637-1561, USA bDepartment of Accounting, University of Oregon, Eugene, OR 97403-1208, USA CDepartment of Accounting, University of Washington, Seattle, WA 98195, USA (Received October 1994; final version received October 1995)

Abstract This paper examines the exercise of employee stock options (ESOs) by executive officers. We document a positive relation between the variance of ESO returns and the remaining life of the option at exercise, and show that the strength of the relation is reduced by the extent the firm hedges the returns on the ESO. We thus provide empirical evidence of a link between an ESO's expected term and its investment risk to the executive, and document that some firms provide a hedge against option risk.

Key words." Management compensation; Employee stock options; Early exercise; Risk diversification; Hedging JEL classification: J33; M41

1. Introduction T h e v a l u a t i o n of e m p l o y e e stock o p t i o n s (ESOs) has received significant a t t e n t i o n f r o m a c a d e m i c s a n d practitioners. A c a d e m i c s use E S O v a l u a t i o n

* Corresponding author. We would like to thank Sunnie Chu and Bruce Krewson for providing valuable research assistance on the project. We also acknowledge helpful comments from Bob Bowen, Ilia Dichev, Michael Eames, Steve Huddart (the referee), Jane Kennedy, Ray King, Joseph Limacher, Dale Morse, Susan Moyer, Mark Peecher, D. Shores, Ross Watts (the editor), and workshop participants at the Universities of Oregon and Washington. 0165-4101/96/$15.00 @ 1996 Elsevier Science B.V. All rights reserved . . . .

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T. Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

models to estimate total compensation (for example, in studies of the pay for performance relation) or to assess the incentive effects of equity securities. From a practitioner standpoint, the recent Exposure Draft (1993) issued by the Financial Accounting Standards Board (FASB) has directed attention toward measuring the cost of ESO grants, for both internal decision making and external reporting purposes. As pointed out in the FASB's Exposure Draft (and reemphasized in the roundtable discussion hosted by the FASB on April 18, 1994), a key source of the difference between the value of an employee stock option and a publicly traded option is the likelihood of early exercise.1 Specifically, theories proposed by Huddart (1994) and Mozes (1995) suggest that managers (who are subject to constraints that inhibit their ability to reduce their investment risk by selling ESOs) will tend to exercise ESOs prior to maturity in order to diversify their investment portfolio, In contrast, selling a traded option generally dominates early exercise. Therefore, option pricing models applicable to traded options will overstate the expected term for an ESO. As the investment risk of holding the option increases, the probability of early exercise increases, and the amount of the overstatement increases. Huddart (1994) and Mozes (1995) suggest that managers, due to their inability to sell their ESOs or sell short the underlying stock, are fully exposed to the risk of the ESOs. However, Hemmer (1993) develops a model in which f i r m s use various compensation components to provide managers with a hedge against option risk. In this context, increases/decreases in the value of the manager's option portfolio are offset to a certain degree by lower/higher total compensation. This type of contract gives managers appropriate incentives while limiting their exposure to risk. The extent to which compensation offsets changes in the value of the manager's option portfolio reduces the benefit derived from the reduction of risk through early exercise. In the extreme, if the executive is fully hedged, i.e., the firm contracts to totally offset changes in the value of the manager's option portfolio by changes in compensation, the exercise of an ESO would have no beneficial effect on the manager's investment risk. In that case, the risk of holding the option should have no effect on the manager's exercise strategy and the exercise patterns of ESOs should not differ from those of traded options. 2

1Other value-relevant factors are the exercise price, the current price of the underlying stock, its expected volatility, the expected dividend yield on the stock, and the risk-free interest rate during the expected term of the option. Huddart (1994), Coopers and Lybrand (1993), and Hemmer, Matsunaga, and Shevlin (1994) show that the expected term is a significantdeterminant of the value of ESOs. ZThis assumes that there are no differences between traded options and ESOs with regard to liquidity needs, tax effects,exercise restrictions, or inside information.

T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 45-68

47

The presence of early exercise, the extent to which compensation hedges option risk, and the relation between early exercise and hedging are all empirical questions. However, little evidence exists on these issues. We use data on 110 option exercises by 74 top executives during 1990 to examine the relations between the investment risk of the option and the number of years remaining on the life of the option at the time of exercise. The results support the predictions that a) the extent of early exercise is positively related to the risk of holding the ESO, and b) the strength of the relation is reduced by the extent the firm hedges the returns on the ESO. 3 These results suggest that, for top executives, the overvaluation of the Black Scholes model resulting from 'early' exercise is increasing in the variance of returns on the option. However, the strength of this relation depends upon the correlation between compensation and changes in the value of the executive's ESO portfolio. The results also provide evidence that some firms provide top executives with a hedge against option risk and that the extent of the hedge influences the executive's exercise decision. As previously noted, formal empirical evidence on the extent of, and the factors explaining, early exercise is scarce. One reason for this scarcity is the lack of publicly available data. In concurrent research, Huddart and Lang (1995) obtain confidential ESO data from eight corporations. Their data describes the exercise behavior for approximately 50,000 employees at all levels of the organizations. Since they have the ESO grant history, they are able to study the fraction of a grant exercised in a given month. They find that this fraction is positively associated with the market-to-strike ratio, variance of stock returns, proximity to vesting dates, and time to maturity. They also find that exercise appears to occur in periods in which the stock price is rebounding from a previous fall. Our study differs from Huddart and Lang (1995) in that we use publicly available data (which increases the number of firms but restricts the sample to top executives and ESOs that were exercised). Additionally, we define ESO risk as the variance of ESO returns (which is a function of the variance of the underlying stock returns and the market-to-strike ratio) and examine how the existence of a hedge influences the executive's exercise decision. While Huddart and Lang's results suggest that stock price variance is not a significant determinant of ESO exercise for top level executives, our results for ESO risk and hedging indicate that top level executives are sensitive to ESO risk. However, since lower level employees are not likely to have hedged

3As discussed in detail below, the extent of the hedge is estimated by a manager-specific regression of total annual compensation (salary + bonus + restricted stock + estimated value of ESOs granted within the year) against the change in the value of the manager's option portfolio.

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72 Hemmer et al. / Journal of Accounting and Economies 21 (1996) 45 68

c o m p e n s a t i o n contracts, c a u t i o n s h o u l d be exercised in generalizing o u r results to the general p o p u l a t i o n . 4 T h e p a p e r p r o c e e d s as follows. Section 2 s u m m a r i z e s the theories r e g a r d i n g the incentive effects of using o p t i o n s in c o m p e n s a t i o n c o n t r a c t s as p r e s e n t e d in H u d d a r t (1994) a n d H e m m e r (1993). T h e theoretical d e v e l o p m e n t is used to derive the hypotheses. Section 3 presents the research design used to test the hypotheses. T h e results of the tests are discussed in Section 4, a n d conclusions are p r e s e n t e d in Section 5.

2. Summary of theory T h e focus of this s t u d y is to investigate the relation between the early exercise of E S O s a n d the m a n a g e r ' s e x p o s u r e to risk. In this section we s u m m a r i z e a n d e x p a n d on existing theories to p r o v i d e a f r a m e w o r k for relating the exercise of E S O s to risk. T h e a s s u m p t i o n s u n d e r l y i n g these m o d e l s eliminate c o n s i d e r a t i o n s , o t h e r t h a n risk, that c o u l d result in early exercise. H o w e v e r , from an e m p i r i c a l s t a n d p o i n t , early exercise c o u l d be m o t i v a t e d by several reasons, e.g., dividends, m i n i m i z i n g tax p a y m e n t s , t r a d i n g on inside i n f o r m a t i o n , liquidity (need to c o n v e r t the security to cash), or the a n t i c i p a t i o n of the t e r m i n a t i o n of e m p l o y m e n t . 5 W e discuss o u r m e a n s of c o n t r o l l i n g for these motives in Section 3. H u d d a r t (1994) presents a m o d e l t h a t links the risk of E S O s to their early exercise. In his m o d e l m a n a g e r s h o l d a p o r t f o l i o that consists of a risk-free b o n d , c o m m o n stock in the e m p l o y e r firm, a n d call o p t i o n s on the c o m m o n stock in the e m p l o y e r firm. 6 At a n y p o i n t in time, a m a n a g e r has the choice of exercising the call o p t i o n a n d investing the net p r o c e e d s (i.e., the fair m a r k e t value of the stock less the exercise price a n d taxes) in the firm's c o m m o n stock o r the risk-free b o n d . If the m a n a g e r retains the o p t i o n , the m a n a g e r is able to defer

4A recent article in Fortune (July 24, 1995, p. 28), discussing ESO plans for large industrial corporations, states that '97% of these options go to the top 15 executives in these companies, according to the research firm Institutional Shareholder Services'. Thus, for many firms the ESO exercise behavior for top executives is an important issue. 5See Carpenter (1994) and Cuny and Jorion (1995) for discussions regarding the early exercise of options relating to the termination of employment. 6Huddart assumes non-dividend-paying securities, constant tax rates, no private information, and no liquidity or consumption needs. Mozes (1995) presents a similar model with qualitatively similar predictions with respect to early exercise being positively associated with the risk of ESOs.

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49

payment of the exercise price and taxes. 7 On the other hand, if the manager exercises the option he is able to reduce his portfolio risk. 8 His analysis assumes that managers are unable to diversify the risk of holding firm-specific securities, i.e., an employee faces constraints, such as firm-specific human capital, wealth limitations, security regulations regarding insider trading, and nontransferability provisions, that do not apply to market participants in general. Since the market price of the common stock is set by traders that are not subject to such restrictions, the expected return of firm-specific securities does not compensate managers for the full amount of the risk borne by the manager. Accordingly, the individual manager may rationally choose to exercise options early even if such exercise results in a loss in expected value. Huddart's analysis of optimal ESO exercise does not consider the interaction between a manager's other compensation components and the value of his E S O s . 9 This becomes important when one considers the implications of Hemmer (1993) for the early exercise of ESOs. In his model, firms solve a standard agency problem by providing managers with options and a hedge against option risk such that if the manager takes the firm-value-maximizing action, overall compensation is risk-free. Only if the manager takes an undesired action does the payoff on the compensation contract become risky. Since in equilibrium the total payoff to the manager is risk-free, the firm avoids paying the manager a risk premium. In other words, while the manager's individual compensation components may appear to be risky when viewed independently, they may actually reduce the manager's overall risk by acting as a hedge against changes in the value of the manager's ESO portfolio. To the extent the model presented by Hemmer is descriptively valid, it suggests that, in equilibrium, hedged managers do not bear the risk of holding ESOs and therefore have no incentive to exercise their ESOs early to diversify their portfolio, l o Indeed, if the fully hedged manager exercises his ESOs without being able to eliminate the risk of the compensation components set up to

7This assumes that the options are Nonqualified Stock Options for tax purposes. Exercise does not trigger a taxable event if the options are Incentive Stock Options (as defined by IRC sections 421 and 422), unless the options are disqualified (as discussed in Matsunaga, Shevlin, and Shores, 1992). SThis assumes that the future mix between options and other compensation components is not influenced by the manager's option holdings. 9Although Lambert, Larcker, and Verrechia (1991) do not specifically address hedging, they suggest that the risk of an individual component of the manager's portfolio depends upon the other components of the manager's wealth. ~°Saly's (1994) findings with regard to the repricing of underwater options are consistent with hedging. In her paper, firms increase the wealth of managers (by reducing the exercise price of options) to offset declines in the value of their option portfolio resulting from market-wide price movements (such as the 1987 stock market crash).

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provide the hedge, such exercise will strictly increase the risk of his overall portfolio. Although in Hemmer's setting a perfect hedge is optimal, a less than perfect hedge could well be optimal under more general circumstances. For example, options may be used to provide incentives along a number of dimensions (one example is to encourage managers to select risky investments). Firms are also likely to face constraints that reduce their ability to hedge ESO returns. The concept of a risk-free contract implies that changes in the value of the manager's ESO portfolio are offset by changes in the manager's compensation. Thus, compensation paid to the manager in a 'good' year (i.e., when the value of the manager's option portfolio increases) is lower than the compensation paid in a 'bad' year. Due to the threat of litigation and public pressure, members of the board of directors may be reluctant to design executive compensation contracts that have a negative correlation between annual compensation and the changes in stock price. In addition, the hedge can only extend to a limited set of possible outcomes. For example, the firm cannot maintain the hedge if the firm files for bankruptcy protection. In a hedged contract compensation is negatively related to the firm's market performance, but bankruptcy courts are unlikely to approve compensation payments that are in excess of past amounts. Thus, while the basic argument that hedging can be used to align the risk sharing and incentive effects of options remains valid, it is unlikely that all firms will offer a perfect hedge for the options included in the manager's compensation package. However, if a manager's ESOs are hedged, then the extent of the hedge provided by the firm reduces the benefits to the manager from the risk reduction strategies discussed in Huddart (1994). The stronger the hedge, the less the risk that can be eliminated through exercise. Indeed, as discussed previously, for very strong hedges, early exercise can actually increase a manger's exposure to risk. The Hemmer model, and our analysis thereof, applies to cases in which compensation is used to hedge ESO risk. In contrast, the effect of a positive correlation between ESOs and other components of compensation on early exercise is less clear. Intuitively, the positive correlation could amplify the risk of holding ESOs. On the other hand, it could be argued that, unlike the negative correlation of a hedge, the magnitude of the positive correlation has no effect on the manager's exposure to ESO risk. By exercising an ESO early, the manager is able to reduce his risk by the extent of the volatility of that option, and this reduction is achieved regardless of the strength of the positive correlation. Thus, the issue of which argument is descriptively valid is an empirical question. We therefore examine the effect of the strength of a positive correlation on early exercise. However, since this goes beyond Hemmer's model, on which we base our hedging prediction, we do not make formal predictions regarding the effect. In conclusion, we expect the strength of a hedge (i.e., the absolute level of negative correlation between changes in ESO value and the level of other compensation) to be negatively related to the reduction in risk a manager can

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51

achieve t h r o u g h early exercise. Thus, for hedged m a n a g e r s we predict an inverse relation between the strength of the hedge and the propensity to exercise early. These predictions are summarized formally by the following hypotheses (stated in alternative form): H I : The extent of early exercise is positively related to the variance of the returns on the option. H2: The strength of the relation between the extent of early exercise and the variance of the returns on the option is negatively related to the extent to which option risk is hedged by the firm. F o r purposes of our study, H 1 can be stated as predicting that the greater the variance of returns on the option, the greater the n u m b e r of years remaining to expiration u p o n exercise. Similarly, H2 predicts that the hedge d a m p e n s the strength of the relation between early exercise and E S O variance. In order to set up the empirical tests to follow, the hypotheses can be characterized as follows. Let Y represent the extent of early exercise, as2 represent the variance of returns on the option, and Hedge represent the extent changes in the value of a manager's option portfolio are offset by compensation. Then (assuming linearity and letting 7 represent a constant), the basic relation suggested by the hypotheses can be described as Y = 7 (1 -- Hedge)a~o.

(1)

If the m a n a g e r is not hedged, Hedge = 0 and the extent of early exercise is positively related to the variance of returns on the option. At the other extreme, if the m a n a g e r is perfectly hedged, i.e., for every dollar change in the value of the manager's option portfolio, c o m p e n s a t i o n changes by a dollar in the opposite direction, then Hedge = 1 and the manager's exercise behavior is not related to the variance of option returns.

3. Empirical tests 3.1. Sample selection

Panel A of Table 1 summarizes the results of our sample selection procedure. Exercises of employee stock options are identified from the 'Official S u m m a r y of Security Transactions and Holdings' published by the Securities and Exchange C o m m i s s i o n during the 1990 calendar year. al We choose 1990 because we l~The "Official Summary of Security Transactions and Holdings' summarizes the filing of SEC Forms 3, 4, and 5. Individuals are required to file a Form 3 within 45 days of becoming an officer, director, or an owner of 10% or more of the company. On the Form 3 managers disclose the number

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T. Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

believe it to be a representative year to examine exercise strategies. There were no significant tax or other regulatory changes during 1990 that would have a major effect on manager's exercise strategies. By contrast, projected tax rate increases led to a series of well-publicized ESO exercises at the end of 1992 (see Wolfson, 1993). We focus on a single year because it is very time-consuming to assemble the data necessary for our tests. Exercises of employee stock options are identified if 1) the individual is an officer of the corporation that is likely to appear in the compensation table in the firm's proxy statements, 12 2) the exercise represents at least 10,000 shares, and 3) the exercise price is provided. The first restriction is necessary to obtain data to measure the manager's annual compensation in order to estimate the hedging factor. The minimum number of shares restricts the analysis to transactions that involve a material number of options, i.e., reducing the likelihood of liquiditymotivated transactions. The exercise price is used to estimate the year the option was granted. We also require that data on the issuing firm are available on C R S P (to estimate the variance of the option returns and cumulative returns and to retrieve share prices and dividend yields). In order for a manager to remain in the sample, we require that data are available from the firm's proxy statements for a sufficient number of years to estimate a regression between annual compensation and changes in the value of the manager's option portfolio (i.e., the hedge), as described in detail below.13 The data required include the amount of the manager's compensation, the number of options granted during the year, and the number of options held by the manager.

of shares and options owned as of the filing date. Officers, directors, or 10% owners are required to file a Form 4 on or before the tenth day after the end of each month in which any change in beneficial ownership has occurred. Managers are required to list the number of options exercised, the exercise price of the options exercised, and the date of exercise on the Form 4. They also list the number of beneficial shares owned. Although we can generally determine the total number of options held by the manager from the proxy statements, as a general rule, firms do not disclose data regarding the nature of the options held (time to maturity, exercise price, etc.). In addition, public disclosures are not sufficient to reconstruct the manager's option portfolio using historical grant and exercise patterns. During 1991, perhaps in response to a lack of compliance, the SEC created the Form 5, which is filed by executives who do not file the Form 4 on a timely basis. On the Form 5 managers disclose the number of shares beneficially owned, and the number, exercise price, vesting date, and expiration date of options held. Our sample selection procedure would exclude any managers who exercised options during 1990, but did not report the transaction to the SEC until 1991. We do not believe this will bias our tests, although it likely reduces the power of the tests through a reduction in the sample size. 12An exercise is not recorded unless the individual is listed in the Official Summary of Securities Transactions as CB (Chairman of the Board), P (President), or O D (Officer and Director). 3This restriction also limits the sample to firms traded on the NYSE and AMEX. Proxy statements for NASDAQ firms are not readily available at a reasonable cost.

T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 45 68

53

Table 1 Data on sample firms

Panel A: Summary of sample selection procedures (total of 110 individual exercises) N u m b e r of Managers

Firms

Option exercises recorded a Firms not listed on N Y S E / A M E X

473 (216)

396 (184)

Firms not on C R S P

257 (20)

212 (17)

Retirements

237 (31)

195 (27)

206

168

(132)

(103)

74

65

Unable to determine grant date or insufficient compensation data Final sample

Panel B: Comparison of median sample firm to median Compustat firm (fiscal year ended 1989), all a m o u n t s in Smillions except ratios

Market value of equity Total assets Net income Return on assets Long-term debt/Total assets

Sample firms (n = 65)

All N Y S E / A M E X C o m p u s t a t firms (n = 2,265)

$1,829 $1,688 $124 0.063 0.198

$213 $356 $12 0.037 0.205

Panel C: Distribution of two-digit SIC codes of sample firms Percentage for all C o m p u s t a t firms

S1C code

N u m b e r of firms

20 26 28 29 34 35 48 53 60 All others

5 4 8 3 3 4 3 3 5 27

7.7 6.2 12.3 4.6 4.6 6.2 4.6 4.6 7.7 41.5

2.5 1.6 5.7 1.6 2.2 5.6 2.2 1.3 4.7 72.6

Total

65

100.0

100.0

Percentage

aExercises recorded include all listings from the 'Official S u m m a r y of Securities Transactions and Holdings' during 1990 that meet the following criteria: a) the manager is listed as Chairman of the Board, President, or as an Officer and Director, b) the number of options exercised is greater than or equal to 10,000, and c) the exercise price is provided.

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The sample excludes managers who left the firm during the 1990 or 1991 calendar years. This requirement reduces noise introduced by transactions related to the departure from the firm since most ESOs require that options be exercised within 90 days after the manager leaves the firm (see Carpenter, 1994). Finally, option exercises are excluded from the sample if the grant date of the option exercised could not be ascertained from publicly available data. 14 In order to infer the grant date of an option exercise, we a) determined the exercise price for each option exercised from the Form 4 (obtained from the Securities and Exchange Commission), b) determined the exercise prices of options granted to the manager in each year from past proxy statements and annual reports, and c) found the grant year in which the exercise prices of the sample matched the prices of the options granted. In two cases options exercised could have come from either of two consecutive years. In such cases, the grant year is coded as the average of the two years. The above procedures yielded a sample of 110 option exercises by 74 top executives employed by 65 separate firms. Ideally, we would like to have detailed data (exercise prices and maturity dates) for all options held in the manager's portfolio. We could then examine the options exercised relative to the options available. However, because we only have limited data on the options held (but not exercised) by the manager, we restrict our analysis to the options that were exercised. Panels B and C of Table 1 present descriptive statistics for the sample firms and for all Compustat firms, as of their 1989 fiscal year-end. As might be expected given the data requirements (and noting that all of the managers held 'in-the-money' options), the median values for size and profitability measures for the sample firms exceed the corresponding median values for all Compustat firms. The sample also contains a higher proportion of firms from SIC codes 20, 26, and 28 (food and kindred products, paper and allied products, and chemicals and allied products, respectively) than the population of all Compustat firms. 3.2. Design o/'tests o f i l l and H2

The following regression is used to test our hypotheses regarding the effects of option risk and hedging on the extent of early exercise: 2 Time = flo + fllas2 + fl2H a~,, + fl3H +G2, , + f i 4 H

+ fl6Prch.q + fivPrch.q

+ fisD~ + e,

+fisH +

(2)

1~During the sample period, maturity dates of options are rarely publicly disclosed. We therefore use the grant date and the option life to infer lhe year in which the option expires,

T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 45 68

Time 2 (~so

H-

H--

Prchg Prchg Dear

55

= remaining life of the option (in years), = variance of returns on the option (as calculated in (6)), = q - 1 where q is the estimated coefficient from the compensation regression (7) when the p-value of a one-tailed test that q < 0 is below a given cut-off value, and 0 otherwise, = q where r/is the estimated coefficient from the compensation regression (7) when the p-value of a one-tailed test that q > 0 is below a given cut-off value and 0 otherwise, = percentage change in the price per share over the 60 trading days prior to exercise, = Prchg if Prchg < 0 and 0 otherwise, = 1 if the cumulative market-adjusted returns for the firm are significantly negative during either the 12-month period subsequent to exercise or for a 6-month subperiod beginning 6-month subsequent to exercise and 0 otherwise.

We use the remaining life of the option at the exercise date as our measure of early exercise, and relate that dependent variable to two test variables. H1 predicts a positive relation between the extent of early exercise and the variance of the returns on the option, i.e., fll > 0. On the other hand, H2 predicts the strength of the relation will be reduced by the extent to which the manager is hedged, i.e., /~2 < 0. We discuss the measurement of the variance of option returns in Section 3.3 and the measurement of the hedge in Section 3.4. The remaining independent variables in Eq. (2) serve to control for a) the interaction of a positive correlation between compensation and changes in the value of the option portfolio with the option variance, H + a~o, 2 b) any direct effect of the hedge, H - , c) any direct effects of the positive correlation between compensation and changes in the value of the option portfolio, H +, d) any effects of price changes during the calendar quarter preceding the exercise date that might have triggered exercise, Prchg and Prchg-, and e) the possibility of early exercise by managers based on inside information, Dc,r. Each of the variables is discussed in greater detail in Section 3.5, and as discussed there, f18 is expected to be positive. No predictions are made for the other coefficients. Finally, because Time takes on discreet values with regular intervals, we use polychotomous probit to estimate (2). Although the main tests consider each exercise as a separate observation, we also estimate the regressions using the first exercise for each manager, with qualitatively similar results. 3.3. Measurement ~?f the variance o f option returns We use the variance of returns on the ESO to proxy for the investment risk of the ESO. Because firms do not disclose information on the manager's private investment portfolio, we are not able to estimate the incremental effect of the

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option to the manager's private investment portfolio risk. In addition, the correlation of option returns relative to the m a r k e t (i.e., an option beta) is not an appropriate measure of risk for a m a n a g e r who does not hold a fully diversified portfolio (i.e., the m a n a g e r has firm-specific capital, etc.), and the net reduction in risk depends u p o n the manager's use of the net proceeds. According to Cox and Rubenstein (1985), the variance of returns on a stock 2 can be described as a function of the variance of returns on the option, a,o, underlying stock, a~, as follows:

2 z i~so

~,

(3)

where S ~SO Y2 - S O 6S "

(3a)

In order to calculate the variance of the option we use the dividend-adjusted version of the Black-Scholes model from M e r t o n (1973), in which the value of the option at time t can be described as follows: (4)

SO = Se-~T N ( d l ) - X e - r W N ( d 2 ) ,

dx =

l o g ( S / X ) + [r - 6 + 0.5~2]T

a~,,~

'

d2 = dl - a,x/-T, S X r T 6

= = = = =

(4a) (4b)

fair market value of the underlying stock, exercise price, riskless rate of interest, time to maturity, annualized dividend yield.

It follows (see Cox and Rubenstein, 1985, p. 210) that 6SO

6S - e - 6 r N ( d l ) '

S f2 = ~ e 6rN(dl).

(5) (5a)

Therefore, 2 .~ ~S tTso

e_~rN(dl)a 2

(6)

The fair market value of the stock on the date of exercise is obtained from the ' S u m m a r y of Securities Transactions'. The riskless rate of interest is the

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57

annualized average 90-day treasury bill rate for 1990.15 The variance of returns on the underlying stock is measured as the annualized variance of monthly returns measured for a five-year period ending just prior to the start of the 1990 fiscal year. 16 The dividend yield is measured as the annualized value of the firm's last quarterly dividend for the 1990 fiscal year divided by the year-end price.

3.4. Measurement of the hedge As discussed in Section 2, the risk of holding an option can be reduced (or totally eliminated) if the firm provides a hedge against changes in option values. The existence of an employer-provided hedge against option risk implies that the firm adjusts total annual compensation to offset changes in the value of the options held by managers. Therefore, a negative correlation between annual compensation and the change in the value of options held by the manager indicates the existence of a hedge, and the magnitude of the correlation measures the extent of the hedge. The degree of hedging is estimated for each manager from a time-series regression of annual compensation against the estimated change in the value of the manager's option portfolio. Dummy variables are included in the regressions for each job title to control for changes in compensation levels resulting from promotions. The sample period for the compensation regressions extends from the manager's first appearance in the proxy statements (or 1978 whichever is later) through 1992. The change in managerial wealth resulting from compensation is regressed against the change in wealth resulting from holding options as follows: 17

Compt = ~Xo+ ~

o~iDit +

rlAOPt + et,

(7)

i=1

Compt = = = AOPt = ~, = Di n

annual compensation in year t, dummy variable corresponding to the manager's job title, total number of job titles held by the manager, change in the value of the manager's option portfolio, error term.

Annual compensation is estimated as the sum of the cash payments (salary plus bonus), value of restricted stock (or phantom stock), and value of stock

a5This assumes a flat term structure for interest rates. ~6This procedure is recommended by Alford and Boatsman (1994). 17The underlying theory relates to changes in a manager's wealth. Ignoring consumption, annual compensation (rather than the change in annual compensation) and the change in the value of option holdings both reflect a change in the manager's wealth.

58

12 Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

options granted to the manager during the year. Compensation data and job titles are obtained from the proxy statements. If the value of the restricted shares on the date of grant is not disclosed, the value is assumed equal to the exercise price of options granted during the year (if available) or the year-end stock price. The value of stock options granted is estimated using the dividend-adjusted Black-Scholes model [see Eq. (4)].18 All dollar amounts are expressed in 1978 dollars using inflation rates from Ibbotson (1992). We also assume a 5% growth rate in real compensation, and deflate annual compensation by 5% per year. Conference Board statistics indicate that during the 1980s, which comprises a major portion of the estimation period used in this study, average current compensation (salary + bonus) for CEOs in manufacturing industries increased in real terms by 2% to 3% per year. The Conference Board surveys also indicate a rise in the use of restricted stock and stock options (not included in current compensation) during this period. Therefore, the 5% rate is considered to be a reasonable approximation.19 Because, as previously noted, data regarding the exercise prices and remaining lives of the unexercised options held in the portfolio are not available from public sources, we assume that the sensitivity of option values to changes in share price is constant. Violations of this assumption induce unavoidable measurement error in the estimation of q. The change in the value of options held by the manager is estimated as follows: A O P , = (p, - p , _ 1 ) N O P , ,

p, NOP,

(8)

= price per share of common stock at the end of fiscal year t, = number of exercisable options held at the end of fiscal year t.

The price per share is adjusted for splits and, consistent with our estimate of annual compensation from (7), the change in the value of the option portfolio is

1Sin order to calculate the Black Scholes value of options granted it is necessary to estimate r, a 2, ~'i and T. The parameters are estimated as follows: r - average 90-day treasury bill rate for the year, a 2 - annualized variance of monthly returns measured over the previous five years, 6 - last quarterly dividend (annualizedl divided by the year-end price. In order to estimate T, the maximum life of options granted is determined from the proxy statements. The T used in the calculation is the T that maximizes the Black-Scholes value of the option subject to the T being less than or equal to the maximum. This procedure implicitly assumes that the manager is fully hedged and will hold the option until the gain on exercise exceeds the BS value. To the extent that the manager follows a different exercise strategy, this procedure will overstate the value of the option. ~The tests are also conducted without the deflation for real compensation growth. The results are qualitatively similar to the reported results.

T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 45 68

59

expressed in constant (1978) dollars. The number of exercisable options held is obtained from the proxy statement. The end of the year option portfolio is used because it includes options held at the end of the year that became exercisable during year t, excludes options exercised during year t (the risk of which does not need to be hedged), and excludes options granted during the year that might form part of the hedge (most option plans require at least a one-year vesting period). 2° For observations prior to 1984 (when the proxy statement disclosed the actual number of options held) N O P t represents the total number of options held at the end of year t less the number of options granted during year t (which could be used to form part of the hedge). Recall that H2 is derived from a theory regarding hedged contracts. As a result, the hypothesis only addresses one tail of the distribution oft/(i.e., q < 0). Theoretically, the hedge is equal to -r/, for all r / < 0. However, we have a relatively small number of degrees of freedom available to estimate Eq. (7). The median number of annual observations is seven and the median number of degrees of freedom for the compensation regressions is three. As a result, there is likely to be a large degree of sampling error in the estimation of q. To obtain some assurance that the true q is less than zero, we define H = - q, if the significance level of a one-tailed test of the hypothesis that r / < 0 is below a specific cut-off and zero otherwise. The tests are conducted using cut-offs of 0.20, 0.25, 0.30, and 0.35. Again, the relatively high cut-off levels result from the small number of degrees of freedom used to estimate (7). Panel A of Table 2 reports descriptive statistics on the distribution of r/and the p-values of one-tailed tests that r / < 0. As indicated by the data in Panel B of Table 2, the percentage of observations considered as hedged for the samples of individual exercises (individual managers) ranges from 24.5% (24.3%) at the 0.35 cut-off to 10.9% (12.2%) at the 0.20 cut-off. Panels C and D of Table 2 present comparisons of subsamples grouped by the hedging classification of the manager. We use a cut-off of 0.30 to define the two groups in order to provide an adequate number of observations to make a reasonable comparison. Panel C presents data on the firms in the two groups, while panel D presents comparison data for the managers in each group. Although none of the differences are statistically significant at conventional levels, the data in panel C suggest firms in our sample that offer hedged contracts tend to be smaller with higher growth. The data in panel D suggest that, although the differences are not statistically significant, managers who are hedged tend to have lower share ownership. Z°Proxy statements issued between 1984 and 1991 only disclosed the number of options held by managers that were exercisable or that become exercisable within 60 days of the proxy statement date (i.e., options granted but not vesting within 60 days are excluded). Therefore, the measure likely understates the number of options being hedged (although the extent of the understatement depends both upon the pattern of option grants and the vesting provisions).

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T. Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

3.5. Measurement of control variables In order to investigate the effect of a positive correlation between compensation and changes in the value of the manager's option portfolio we define a variable, H +, that is equal to q if the significance level of a one-tailed test that Table 2 Descriptive data regarding the presence of a hedge A manager is classified as 'hedged" if the p-value from a one-tailed test that r / < 0 is below a cut-off value, where r/ is the estimated coefficient from a regression of annual compensation against the annual change in the value of the manager's ESO portfolio.

Panel A: Data on the cross-sectional distributions of q and p-values that ~I < 0 estimated from the compensation regressions (annual data from 1979 1992) Compt = ~o + ~ o:iDi, + qAOP, + ~, i=1

q p-value for one-tailed test that r / < 0 Number of observations

Mean

Std. dev.

0.248 0.637

0.631 0.305

8.176

3.177

0.05

Median

0.95

- 0.285 0.084

0.116 0.760

1.724 0.996

3.000

9.000

12.000

Panel B: Frequency of hedged contracts

Cut-off p-value Cut-off p-value Cut-off p-value Cut-off p-value

= = = =

0.20 0.25 0.30 0.35

Exercises (n = 110)

Managers (n = 74)

Firms (n = 65)

12 19 21 27

9 13 15 18

6 11 12 15

Panel C: Comparison of firms by hedging classification using 0.30 cut-off p-value to define hedged firms (1989 fiscal year-end data) Hedged mean (median)

Nonhedged mean (median)

Number of firms

12

53

Total assets

$3,197.6 ($1,172.3)

$5,802.2 ($1,869.4)

Return on assets

0.077 (0.092)

Long-term debt/Total assets Market/Book

Difference in means t-statistic

Wilcoxon signed ranks Z-statistic

- 0.878

- 0.719

0.053 (0.058)

1.259

1.446

0.207 (0.184)

0.204 (0.200)

0.055

- 0.685

2.674 (2.366)

2.105 (1.744)

1.478

1.327

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T. Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

Table 2 (continued) Panel D: Comparison of executives by hedgin9 classification usin 9 0.30 cut-off p-value to define hedged executives (based on median values for each manager over the sample period)

Hedged mean (median) Compensation $465.9 (in thousands) ($307.5) Number of options held 211.9 (in thousands) (103.3) Number of shares held (in thousands) Percentage of shares held Comp,

Di n AOP,

e,

= = = = =

Nonhedged mean (median) $370.2 ($283.2) 210.3 (97.7)

Difference in means t-statistic

Wilcoxon signed ranks Z-statistic

1.075

1.129

0.012

0.820

203.0 (44.7)

424.5 (116.0)

- 0.575

- 1.654

2.2 (*)

3.8 (*)

-- 0.596

- 1.132

annual compensation in year t, dummy variable corresponding to the manager's job title, total number of job titles held by the manager, change in the value of the manager's option portfolio, error term.

*Median individual had beneficial ownership of less than I% of the outstanding shares.

r / > 0 is b e l o w a specific cut-off value a n d zero otherwise. W e then interact H + with o p t i o n v a r i a n c e a n d a d d t h a t v a r i a b l e to the regression. In short, q has been t r a n s f o r m e d by setting the m i d - r a n g e of the d i s t r i b u t i o n equal to zero a n d s e p a r a t i n g the b o t t o m a n d t o p ends of the d i s t r i b u t i o n into H - a n d H +. As n o t e d earlier, this t r a n s f o r m a t i o n of q is m o t i v a t e d by c o n c e r n with large s a m p l i n g e r r o r in the e s t i m a t e d r/s. Also note t h a t the sign of H has been reversed so t h a t it is i n c r e a s i n g in the extent of the hedge. F o r e c o n o m e t r i c completeness, we also a d d two variables, H - a n d H +, to c o n t r o l for a n y direct effects of the hedge a n d the positive c o r r e l a t i o n , respectively. T h e s u m m a r y of t h e o r y in Section 2 does n o t a d d r e s s the effect of the hedge, itself, on early exercise. Instead, the t h e o r y suggests t h a t the hedge reduces the incentive to exercise the E S O early in o r d e r to reduce e x p o s u r e to risk. Therefore, the v a r i a b l e of interest is the i n t e r a c t i o n of the hedge with the volatility of r e t u r n s on the ESO. As n o t e d earlier, early exercise c o u l d o c c u r as a m e a n s of reducing taxes, in a n t i c i p a t i o n of the t e r m i n a t i o n of e m p l o y m e n t , liquidity, or t r a d i n g on inside i n f o r m a t i o n . W e c o n t r o l for the first two factors in o u r s a m p l e selection criteria by c h o o s i n g a y e a r w i t h o u t a n y significant relevant tax changes a n d by excluding a n y executives t h a t left the firm d u r i n g the following year. L i q u i d i t y - m o t i v a t e d t r a n s a c t i o n s are a s s u m e d to be r a n d o m a n d a d d noise to the estimation.

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T. Hemmer et al. / Journal o f Accounting and Economics" 21 (1996) 45-68

We control for the third factor (trading on inside information) by including the variable Dear in the regression model. A top executive with private information which indicates a future decline in share price might exercise early in order to capture the temporarily high current share price. In such cases, the early exercise is unlikely to be related to risk reduction. During the sample period, SEC rules which required 'insiders' to hold stock acquired through the exercise of stock options for a period of six months mitigated the potential for such exercises.21 However, some managers with information which indicates a future decline in value might exercise early in order to capture the temporarily high share value. Since we are unable to define, ex ante, the proper time period in which to measure the decline in value resulting from the release of the inside information, we compute cumulative market-adjusted returns (CARs) for each firm over two different periods. 22 The first period covers the 12 months subsequent to the exercise of the option and the second period begins 6 months after the exercise and ends 12 months after the exercise. A control variable, D .... is constructed that is equal to 1 if the CAR for the firm is significantly negative (at the 10% one-tailed level) for either of the two periods and 0 otherwise. The statistical significance of the CAR for each firm is assessed using the technique from Patell (1976). If managers act on negative inside information by exercising their options early, we would expect a positive coefficient on Ocar.

In Huddart's (1994) model individuals have a certain price threshold, such that an increase in share price above that threshold could trigger an exercise. We therefore include a variable Prch~l, measured as the change in share price over the 60 trading days (i.e., calendar quarter) preceding the exercise date deflated by the stock price at the beginning of the period in order to control for exercises

21As noted in Matsunaga et al. (1992), the short-swing profit rules were changed in May of 1991 to allow insiders to sell shares acquired upon the exercise of ESOs immediately. Because the holding period rules were still in force during our sample period, individuals who exercised ESOs were still exposed to the risk of holding the stock for a six-month period. Thus, although the early exercise of the ESO allows the manager to reduce his risk earlier than he would had he continued to hold the ESO, the exercise does not allow the manager to immediately sell the stock and diversify his portfolio. 2ZCumulative abnormal return is estimated as the market-adjusted return using the CRSP equal-weighted index. Since the value of the option is based on actual stock price, not marketadjusted stock price, the raw return might appear to be the relevant variable. However, we would like to measure the extent of the manager's firm-specific inside information and, ex post, a stock price increase or decrease could be attributable to market-wide trends. Indeed, from July 1990 to June 1991, the market rose 23.5°/,, (using the CRSP equal-weighted index) and only one firm had significant negative cumulative raw returns (the firm also had negative abnormal returns).

Z Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45 68

63

that are triggered by price increases. 23 As s h o w n in T a b l e 3, a s u b s t a n t i a l n u m b e r of o u r exercises are associated with price decreases over this period. H u d d a r t a n d L a n g (1995) present evidence that the association between price changes a n d the p r o b a b i l i t y of exercise depends u p o n the direction of the price change. We therefore include a separate variable, P r c h g - , for the negative price changes over this period (i.e., Prch9 includes all price changes, while for P r c h g all positive price changes are set equal to zero) to isolate the price declines. 24 P a n e l A of T a b l e 3 presents descriptive statistics for the regression variables. T h e m e d i a n r e m a i n i n g life of the E S O u p o n exercise is four years.25 There are 36 (33%) o b s e r v a t i o n s for which Dear is equal to one. C o n s i s t e n t with H u d d a r t a n d L a n g (1995), the negative m e d i a n Prch9 indicates a general decrease in prices prior to exercise (Prch9 is negative in 64 cases). The low m e d i a n variance of E S O returns of 0.136 reflects the sample bias towards large, successful firms. The m e d i a n variance of stock returns for sample firms of 0.073 (not reported) is less t h a n the m e d i a n share price variance of 0.233 reported by Coopers a n d L y b r a n d (1993). P a n e l B of T a b l e 3 presents P e a r s o n correlation coefficients between the variables. As expected, there is a negative correlation between Prch9 a n d ~ ' s2o • This correlation reflects the r e d u c t i o n in ~2 as stock price increases relative to the exercise price.

4. Results The results of e s t i m a t i n g the regression model in Eq. (2) using the 110 i n d i v i d u a l exercises of o p t i o n s are shown in T a b l e 4. The estimated coefficient o n the variance of o p t i o n returns,/~1, is consistently positive a n d significant with

23Huddart's theory actually relates price changes to the probability of exercise at a point in time. That is, an option is more likely to be exercised following a price increase. Because our dependent variable is the number of years remaining in the option's life at the time of exercise (i.e., a measure of the extent of early exercise) rather than the probability the option is exercised at a point in time, the link between the theory and our empirical test is not clear. If managers followa strategy of exercising the option if the market price reaches the threshold price and holding the option until maturity otherwise, large price increases are likely to be associated with early exercises. We therefore include a variable in our regression to control for a relation between early exercise and price increases. 24Huddart (1994) frames his analysis in terms of the ratio of the fair market value of the stock, S, to the exercise price, X, rather than price increases. However, it can be shown that as SIX increases,~.~o approaches a~. Since Cox and Rubenstein (1985) show that as2o_>~ , we expect a negative correlation between S/X and our test variable a~o.We also conducted tests using S/X as a variable (both by itselfand in conjunction with Prch9 and Prch9 ) and our qualitative results on the test variables are unchanged. 25There were eight exercises that took place in the year of expiration, and twelve that took place in the year prior to expiration.

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T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 4 5 - 6 8

Table 3 Descriptive statistics and pair-wise correlations for variables used in the regressions Hedging classification ( H - ) based on a p-value cut-off of 0.30. Panel A: Descriptive statistics reyardiny the distributions o f variables

Time

afro H - * a~o H +* a2o

HH+ Prch 9 Prehy D,.,,

Mean

Std. dev.

4.218 0.169 0.008 0.037 0.033 0.280 - 0.007 - 0.061 0.327

2.436 0.122 0.034 0.069 0.099 0.560 0.155 0.099 0.471

0.05 0.000 0.065 0.000 0.000 0.000 0.000 - 0.285 - 0.285 0.000

Median

0.95

4.000 0.136 0.000 0.007 0.000 0.041 - 0.011 - 0.0l 1 0.000

8.000 0.328 0.024 0.170 0.190 1.724 0.235 0.000 1.000

Panel B: Pearson correlation coefficients ~r2o Time

0.110

~r2o H *•2o H+* a~zo H H+

H - * a2~o

H + * ~.~o

-- 0.075 0.581

-- 0.036 0.036 -0.124

H -

-- 0.012 0,182 0.748 - 0,185

H+

- 0.108 - 0.153 -0.115 0.915 -0.171

Prchy Prchg Time

oL H H +

Prchy Prch~ Dear

Prchg

Prchg

0.140 - 0.249 -0.047 0.061 -0.075 0.170

0.206 -- 0.284 -0.112 - 0.003 -0.134 0.124 0.861

De, r

0.097 - 0.060 -0.126 - 0.058 -0.123 - 0.084 0.154 0.217

= time between exercise and expiration (measured in years), = variance of the returns on the option exercised, = - t/if the manager is hedged and 0 otherwise; a manager is considered to be hedged if the p-value of a one-tailed test that t/is negative is below 0.30, = t/if the p-value of a one-tailed test that q is negative is above 0.70 and 0 otherwise, = change in share price over the 60 trading days prior to exercise deflated by beginning share price, = Prch 9 if Prch9 < 0 and 0 otherwise, = 1 if the cumulative abnormal returns for the firm subsequent to the exercise are significantly negative and 0 otherwise.

p-values ranging from 0.001 (at the 0.20 and 0.25 cut-offs used to identify hedgers in the compensation regressions) to 0.048 (at the 0.35 cut-off). The estimated c o e f f i c i e n t o n t h e i n t e r a c t i o n o f t h e h e d g e w i t h t h e v a r i a n c e , / ~ 2 , is c o n s i s t e n t l y negative and significant with p-values ranging from 0.002 (at the 0.25 cut-off) to 0.051 (at the 0.35 cut-off). These results are consistent with the predictions and H2. The 63.1%

percentages

of concordant

to 65.5%. Conversely,

pairs

the expected

(correct

classifications)

percentage

range

of H1 from

of correct classifications

T. Hemmer et al. / Journal of Accounting and Economics 21 (1996) 45-68

65

Table 4 Probit regressions of early exercise against option variance and adjustments for b o t h negative (hedged) and positive correlations between c o m p e n s a t i o n and changes in the value of the manager's option portfolio n = 110 individual exercises during 1990, p-values in parentheses (based on one-tailed tests for variables with a directional prediction and two-tailed tests otherwise).

Time = flo + fll a2 + fl2H - * a 2 + f13H + * o ' 2 + fl4H

+ fisH + + fl6Prchg + flvPrch 9 -

+ flsDcar + e Significance level cut-offs used to identify positive/negative correlations between compensation and changes in the value of the E S O portfolio. 0.20

0.25

0.30

0.35

fll ( + )

4.030*** (0.001)

4.094*** (0.001)

3.716"** (0.007)

2.468** (0.048)

f12 ( - )

- 17.972"** (0.003)

- 19.192"** (0.002)

- 17.047"** (0.007)

f13 (?)

2.335 (0.578)

2.632 (0.530)

2.517 (0.586)

4.902 (0.286)

f14 (?)

2.022 (0.298)

3.340* (0.080)

4.000"* (0.032)

3.154* (0.066)

fls (?)

- 0.446 (0.396)

- 0.483 (0.360)

- 0.466 (0.419)

- 0.742 (0.197)

f16 (?)

- 1.069 (0.397)

- 0.916 (0.468)

- 0.508 (0.689)

- 0.702 (0.576)

- 10.456" (0.051)

fit (?)

5.075** (0.014)

4.970** (0.015)

4.513"* (0.028)

4.614"* (0.023)

f18 ( + )

0.003 (0.495)

0.005 (0.491)

0.022 (0.459)

0.027 (0.450)

C o n c o r d a n t pairs

65.5%

65.0%

63.3%

63.1%

Log-likelihood chi-square

22.819"**

22.638***

20.182"**

17.532"*

Cut-offs correspond to the significance levels used to assess whether q < 0 in determining the value for H or q > 0 for determining the value for H +.

Time a~o H-

= time between exercise and expiration (measured in years), = variance of the returns on the option exercised, = - r/if the m a n a g e r is hedged and 0 otherwise; a m a n a g e r is considered to be hedged if the p value of a one-tailed test that q is negative is below 0.30, H+ = r/if the p-value of a one-tailed test that q is negative is above 0.70 and 0 otherwise, Prchg = change in share price over the 60 trading days prior to exercise deflated by beginning share price, Prchg- = Prch(4 if Prchg < 0 and 0 otherwise, D¢,r = 1 if the cumulative a b n o r m a l returns for the firm subsequent to the exercise are significantly negative and 0 otherwise. Significant at 10% (*), 5% (**), 1% (***) levels.

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T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 4 5 - 6 8

from a naive strategy of setting Time = 6 (the most frequent observation) would be 19%. In addition, the chi-square statistics from the log-likelihood tests indicate that the independent variables, as a whole, explain a significant part of the variation in the dependent variable. The estimated coefficient for the interaction between the variance of option returns and H + (recall, H + represents the strength of the positive correlation between changes in ESO value and compensation), /33, is not significantly different from zero. In addition, the estimated coefficient is consistently lower than the absolute value of/32, suggesting that the strength of a positive correlation has little influence on risk-reduction-motivated ESO exercises. 26 One curious result is the significant positive coefficient for H (/34). This suggests that the greater the extent of the hedge, the more likely the manager will exercise early. This result seems to be indicative of a systematic difference between the firms that grant the hedge and/or the managers that receive the hedge. For example, this could reflect the endogenous nature of the hedge. Managers who receive a hedge are the ones most likely to exercise ESOs early (i.e., have greater risk aversion). Although further investigation of this issue is beyond the scope of this paper, this appears to be an area for future research. Although the estimated coefficient on the price change variable (/36) is not significantly different from zero at conventional levels, the estimated coefficient for negative price changes,/37, is consistently positive and significant at the 5% level. This suggests that early exercise is more likely to occur when there are small price declines (as opposed to large price declines) over the prior 60-day period. Although we do not have a theoretical explanation, this result is consistent with the empirical result reported by Huddart and Lang (1995). The estimated coefficient on the D~ar variable is positive, but not significantly different from zero. Thus, there is little evidence to support the contention that managers in our sample exercised their ESOs early based on inside information about imminent stock price declines (or relatively poor future stock price performance)} 7

2~To further investigate this relation, we estimated the regression equation using OLS and performed an F-test on the absolute value of [/2 and/~3 The qualitative results of the OLS estimation are similar to those reported in Table 4, and the test of equality of coefficients could be rejected at the 1% level for cut-offs 0.20-0.30 and the 5% level for the 0.35 cut-off. ZTln addition to the results presented in Table 4, we conducted the following sensitivity tests. First, since the data include multiple exercises by the same manager, the observations may not be independent. We therefore conduct the tests on a sample that includes only one exercise for each manager (arbitrarily selected as the first exercise in the data set for the manager). Second, we conduct the tests using alternative measures of 'early exercise' in an attempt to separate exercises that can be justified as maximizing expected value from those in which the manager sacrifices expected value to achieve risk reduction. In the first case, we set Time - 0 if the dividend-adjusted Black-Scholes value of the option is less than the gain on exercise (S-X) at the exercise date. This resulted in 50

T. Hemmer et al. / Journal o f Accounting and Economics' 21 (1996) 45 68

67

5. Summary and conclusions This study provides evidence of a positive relation between the variance of returns on the options and the remaining life of the option at exercise. These results support the contention that managers exercise options early in order to diversify their risk. The study also provides evidence that the relation between option variance and early exercise is reduced if the option risk is hedged by the firm. The risk of holding the option is a joint function of the variance of the returns on the option and the extent to which the firm uses compensation to offset changes in the value of the manager's option portfolio. These results have implications for ESO valuation. A key variable in determining the ex ante expected value of an ESO is the employee's exercise strategy. The evidence from this study suggests that options with higher volatility are likely to be exercised earlier. Estimates of parameters used in ESO valuation should reflect a negative correlation between volatility and expected term, i.e., valuations based on low volatility estimates and a low expected term are understated. However, that conclusion is dependent upon whether the firm provides a hedge against option risk. This study also provides evidence of the existence of a hedge and a means of identifying managers whose option risk is hedged by the firm. Our results suggest that existence of a hedge, and the degree to which it varies, influences the manager's exercise strategy. An interesting extension would be to examine other consequences of the hedge. Further empirical studies that investigate the types of firms that are likely to use a hedge and the effects of the hedge on firm performance would add to our understanding of executive compensation. Several sample characteristics reduce one's ability to generalize the results to the general employee population. First, the results apply to high-level executives, and there are likely to be differences in the exercise patterns of middle managers and top executives. Second, the sample consists of larger, successful firms. Despite these limitations, and the potential measurement error resulting from the reliance on publicly available data, the results provide further insight into the design of executive compensation contracts. The study also documents the early exercise of employee stock options and its relation to option volatility. Yet,

reclassifications from early to nonearly. In the second case, we set Time - 0 if an exercise met the prior condition and the exercise took place within 14 days prior to the next ex-dividend date. This resulted in 11 reclassifications. In the third case, we set Time = 0 if the dividend-adjusted Black Scholes value of the option is less than the gain on exercise, net of the cost of acceleration of the tax liability arising from early exercise. This adjustment recognizes the tax cost involved in the early exercise of a nonqualified ESO and resulted in 29 option exercises being reclassified as nonearly. In all cases, the results from the sensitivity tests (not reported) are qualitatively similarly to those shown in Table 4.

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T. Hemmer et al. / Journal o f Accounting and Economics 21 (1996) 45 68

as mentioned above, there are opportunities for further research on hedged contracts and option exercise patterns. Such research is aided by the changes in proxy statement disclosure rules that took effect in 1993. Because firms now disclose the expiration dates for new option grants, future research can examine option exercise behavior relative to the actual maturity date of the option.

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