On the Timing of CEO
Stock Option Awards
GROUP 1
Celestine
Walter
Jun Yue (Presenter)
Outline
➔ Stock option – What is it, How it works
➔ Opportunistic behaviour
➔ How did some CEO profit from the stock options?
➔ What are the statistical evidences (opportunistic behaviour)?
➔ Take Home Message!
Stock Option – What is it
A stock option is a privilege that gives the buyer the power, but
not the obligation, to buy or sell a stock at an agreed-upon price
within a certain period of time
Generally granted with a fixed exercise price equal to the stock
price on the award date
Stock Option Plan – How it works
i.
Past awards and/or industry norms usually influence the number of
options awarded
ii.
Stock option plan controls the number of options that can be awarded
iii.
Stockholders loathe the potential dilutive effect generated by a large
number of outstanding options
iv.
Accounting rules require a charge to earnings for grants that are issued
in-the money
v.
For scheduled award dates, executives would try to manipulate the
release of information to the capital market, to depress the price on the
date (WHY??)
Rise of Opportunistic Behaviour
Option values: The value that is placed on private willingness to
pay for maintaining or preserving a public asset or service even if
there is little or no likelihood of the individual actually ever
using it. Decreases with the exercise price
Therefore, executives prefer for the stock price to be as low as
possible on the award date to increase the value of their
compensation
Opportunistic Behaviour
Company adopted a stock option plan  Administration of the plan assigned
to compensation committee, who officially determines the size and timing of
stock option grants  Decisions influenced by several reasons
1.
Executives propose the framework of the stock option grant, compensation
committee merely ratifies (backdating)
2.
Close friendships with individual committee members
3.
Influence the timings of the compensation committee meetings, which regularly
coincide with the award date
Self-serving behaviour by executives results in decrease in stock price before
stock option grants and/or increase afterwards
some studies describing an opportunistic timing
Yermack (1997): Around 620 stock option awards between 1992 and 1994.
Awards were opportunistically timed to occur before anticipated stock price
increases
Aboody and Kasznik (2000): 2,039 scheduled option awards between 1992
and 1996. Release of information were opportunistically timed to occur
around fixed option awards
Chauvin and Shenoy (2001): Found evidence of negative abnormal returns
before 783 option grants before 1981 and 1992, but little evidence of positive
abnormal returns following the awards
(WHY??)
Manipulating award dates to their advantage
Unscheduled award date: Executives use their influence to time the awards on
a date when the stock prices are particularly low; granting stock options
retroactively i.e. taking the low point in a recent period to fix a low exercise
price for the benefit of the executives (backdating transactions)
1. Push back the award date if they think that the prices will fall in the near future
(either think that current prices are higher than fundamental value, or expect
prices to fall soon)
2. Promote immediate awards when it is cheap, and unwarranted price drop should
increase price as the capital market realises that the stock is undervalued
3. Advocate immediate awards if expecting future prices to increase, irrespective of
past price performance
Scheduled vs Unscheduled Award Date
Any stock price effect is likely to be weaker around scheduled
awards
Inflation in value: Manipulate award dates (scheduled) VS
control information flow (unscheduled)
Scheduled awards are partially predictable by the capital market,
thus creating trading opportunities that, when exploited, will
tend to remove any price effect
Statistical Evidences
1992 through 2002: Negative abnormal stock returns are
negative before award dates and positive afterward. Evident
around both scheduled and unscheduled awards, but much more
pronounced around unscheduled awards
Although retroactive timing of executive stock option awards
seems dishonest, it is unsettled that it contravenes the
stipulations in the stock option plans
Intensified return patterns around unscheduled awards 
Executives gradually learned how to better time awards to their
advantage or become more aggressive in their timing efforts 
Explains the absence of both negative abnormal returns leading
up to the awards
Scheduled award date: Official grant date must have been set
retroactively. Else, the executives have an informational
advantage, giving them exceptional predictions regarding the
future market movements
Take Home Message!
Do not
buy stocks
unless you have
insider knowledge!