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Risk aversion and block exercise of executive stock options

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  • Grasselli, Matheus
  • Henderson, Vicky

Abstract

It is well documented that executives granted stock options tend to exercise early and in a few large transactions or 'blocks'. Standard risk-neutral valuation models cannot explain these patterns, and attempts to capture the exercise behavior of risk averse executives have been limited to the special case of one option. This paper solves for the optimal exercise behavior for a risk averse executive who is granted multiple stock options. We show that utility-based models do not predict block exercise behavior. Rather, the risk averse executive exercises stock options individually at a sequence of increasing price thresholds. When, in addition, the executive faces frictions such as costly exercise, he faces a trade-off between exercising little and often to maximize return, and exercising larger quantities on fewer occasions to minimize effort. This generates realistic block exercise behavior and yields new predictions. In particular, executives should begin by exercising large blocks of options, but the block sizes should become smaller over time. Our framework also allows us to study the impact of multiple exercise dates on estimates of the cost of options to the company. We find that assuming the executive can only exercise on a single occasion underestimates the cost of the options compared with allowing for optimal exercise behavior.

Suggested Citation

  • Grasselli, Matheus & Henderson, Vicky, 2009. "Risk aversion and block exercise of executive stock options," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 109-127, January.
  • Handle: RePEc:eee:dyncon:v:33:y:2009:i:1:p:109-127
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    References listed on IDEAS

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    1. Optimal 10b5-1 Monetization
      by quantivity in Quantivity on 2011-09-27 12:02:52

    Citations

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    Cited by:

    1. Tim Leung & Kazutoshi Yamazaki & Hongzhong Zhang, 2015. "Optimal Multiple Stopping with Negative Discount Rate and Random Refraction Times under Levy Models," Papers 1505.07313, arXiv.org.
    2. Eikseth, Hans Marius & Lindset, Snorre, 2011. "Backdating executive stock options--An ex ante valuation," Journal of Economic Dynamics and Control, Elsevier, vol. 35(10), pages 1731-1743, October.
    3. Tim Leung & Kazutoshi Yamazaki & Hongzhong Zhang, 2015. "An Analytic Recursive Method For Optimal Multiple Stopping: Canadization And Phase-Type Fitting," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(05), pages 1-31.
    4. Dahlgren, Eric & Leung, Tim, 2015. "An optimal multiple stopping approach to infrastructure investment decisions," Journal of Economic Dynamics and Control, Elsevier, vol. 53(C), pages 251-267.
    5. Carpenter, Jennifer N. & Stanton, Richard & Wallace, Nancy, 2010. "Optimal exercise of executive stock options and implications for firm cost," Journal of Financial Economics, Elsevier, vol. 98(2), pages 315-337, November.
    6. Vicky Henderson & Gechun Liang, 2011. "A Multidimensional Exponential Utility Indifference Pricing Model with Applications to Counterparty Risk," Papers 1111.3856, arXiv.org, revised Sep 2015.
    7. Vicky Henderson & Kamil Klad'ivko & Michael Monoyios, 2017. "Executive stock option exercise with full and partial information on a drift change point," Papers 1709.10141, arXiv.org.
    8. Johannes Gerer & Gregor Dorfleitner, 2016. "A Note On Utility Indifference Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(06), pages 1-17, September.
    9. repec:dau:papers:123456789/9550 is not listed on IDEAS
    10. Sen, Rik & Tumarkin, Robert, 2015. "Stocking up: Executive optimism, option exercise, and share retention," Journal of Financial Economics, Elsevier, vol. 118(2), pages 399-430.
    11. Tim Leung & Haohua Wan, 2015. "ESO Valuation with Job Termination Risk and Jumps in Stock Price," Papers 1504.08073, arXiv.org.
    12. repec:dau:papers:123456789/13098 is not listed on IDEAS
    13. Vicky Henderson, 2012. "Prospect Theory, Liquidation, and the Disposition Effect," Management Science, INFORMS, vol. 58(2), pages 445-460, February.

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