Stocking Up: Executive Optimism and Share Retention

We rigorously model the option exercise and portfolio choice problem of optimistic executives. Our approach extends existing theoretical research by endogenizing both the executive’s investment in company stock and the timing of option exercise. We show that (i) option exercise is delayed by executive optimism and (ii) optimistic executives should not hold options beyond the optimal earlyexercise boundary for unconstrained non-optimistic agents. The analysis suggests that measures of optimism based on option exercise timing will be sensitive to the stock-price process. Our analysis motivates a novel indicator of optimism based on how an executive handles shares acquired on option exercise. Optimistic executives retain some of the shares received, while pessimistic executives sell all shares. Using insider transaction data, we construct a measure of optimism. We set an indicator variable to 1 if a CEO sells less than 99% of the shares acquired from option exercise in one week. Our optimism measure, Share Retainer, is the weighted average of observations of this indicator. In a large cross-section, Share Retainer explains investment intensity and leverage better than previously used optimism measures. We empirically confirm several theoretical implications of the model. ∗The latest version of this paper can be download at http://www.stern.nyu.edu/~rtumarki/research/Stocking.Up.pdf. We thank Alya Al Foori, Jennifer Carpenter, Xavier Gabaix, Nishanth Rajan, Jeffrey Wurgler, David Yermack, and Xianming Zhou for helpful discussion on this project. We also thank seminar participants at the 2009 Finance Down Under Conference, 2009 Hong Kong Joint Finance Workshop, and 2009 London Business School Trans-Atlantic Doctoral Conference for many useful suggestions. †Hong Kong University of Science and Technology, Department of Finance, Clear Water Bay, Kowloon, Hong Kong ‡Leonard Stern School of Business, New York University, 44 West Fourth Street, New York, NY 10012