Executive Optimism, Option Exercise, and Share Retention

Optimism shows up as a pervasive bias in experimental and real-life settings. In the business world, executive optimism is believed to influence a wide range of corporate decisions and policies. However, determining whether an executive is optimistic is not straightforward. Corporate communications featuring key executives can be heavily rehearsed, with words carefully chosen to hide any biases. Interviews with executives may reveal the biases of journalists more than that of the executives.

In our paper, Stocking Up: Executive Optimism, Option Exercise, and Share Retention, recently featured in the Journal of Financial Economics, we propose a robust empirical measure of executive optimism. This measure, which we call Share retainer, is based on observing an executive’s stock transactions that coincide with option exercise. It is motivated by our examination of the optimal option exercise and portfolio choice problem of an optimistic executive who faces a short-sale constraint on company stock.

Our theoretical analysis shows that optimistic executives retain some shares received from exercising options, while non-optimistic executives sell all shares. We prove this for an executive with a general concave utility function. This implies that one only needs to examine whether an executive retains shares received on option exercise to determine if she is optimistic, regardless of her risk aversion, her wealth, or the company’s stock characteristics.

This insight leads to an important advancement over earlier attempts to infer executive optimism based on the timing of option exercise. Optimistic executives should, in general, exercise options on company stock later and at higher prices than non-optimistic executives. However, our analysis shows that optimal option exercise time and price thresholds are greatly affected by factors other than the executive’s behavioral bias, such as her risk tolerance or her wealth. The retention of shares received on option exercise is not influenced by these confounding factors.

A relationship between optimal option exercise timing and risk tolerance is particularly problematic when analyzing how executive optimism affects corporate decision-making. For example, both optimistic executives and risk tolerant executives may be likely to pursue an acquisition. Attributing acquisition behavior unambiguously to executive optimism, therefore, is problematic if the optimism measure used to examine acquisitions also indicates executive risk tolerance. A clean measure of optimism that does not reflect executive risk tolerance, such as Share retainer, helps solve this identification problem.

It is straightforward to compute Share retainer from publicly available information on transactions disclosed by executives to the SEC. Empirically, we show that CEOs who hold shares after exercising behave in ways that optimistic executives are expected to behave in terms of leverage, financing, and acquisition decisions. In fact, Share retainer is more related to these corporate decisions associated with CEO optimism than other option-exercise-based indicators of optimism used in the behavioral corporate finance literature.

We hope Share retainer will make new research in behavioral corporate finance possible. As most studies, including ours, have analyzed large-capitalization companies, our understanding of the effects of executive optimism in small companies is quite limited. Yet, due to their focused business models, these firms may be highly affected by executive biases. Share retainer can be easily computed for all publicly traded US firms, with few approximation assumptions and with standard data sets. Therefore, Share retainer can help researchers shed further light on the causes and consequences of executive optimism.

The full paper is available for download here.