Wednesday, March 11, 2015

Monday, March 9, 2015

Do CEOs time option grants relative to stock splits?

This post is based on a paper coauthored with Erik Devos of UTEP and Bill Elliott of John Carroll University.

To answer this question, we need a quick recap of options and splits.

Stock option grants frequently make up a significant portion of CEOs' compensation packages.  Typically an option is granted to the CEO "at the money" meaning that the strike price is set close to trading price of the stock.  If the stock price increases after the option grant, the value of the option will increase.  This is a standard property of call options and is the prima facie reason for granting them in the first place.

Stock splits are, by and large, cosmetic changes to the stock.  A 2 for 1 stock split results in each share of stock being replaced with 2 shares.   In such a split, the stock price should fall in half, so a $100 stock will split to two $50 stocks.   In reality, the $100 stock splits (on average) into two $51.50 stocks.   In effect a $3 or 3% gain in value occurs on the announcement day of the split.  The key thing to note here is that this is "on average".  Why this occurs is a bit of a mystery and beyond our discussion today.

So given these two factoids - options are granted at the money and stock splits result in a price increase (split adjusted) - when would a CEO most likely want to get an option grant?  
A. Before the split announcement.
B. After the split announcement.
C. The CEO shouldn't care.

If you answered A, then you'd be right - and this is supported by the data.

This figure shows the number of grants made relative to the split announcement.  Clearly, there is clustering before the announcement on day 0.  So what's going on?

Because a grant is granted "at the money", the 3% price bump that occurs on the split announcement results in an immediate increase in value for the holder of the option.  Therefore a CEO would prefer to get his/her options before the split rather than after it. 

But the story is more tricky - as this result holds for scheduled grants (grants which occur at a pre-determined time each year).  This means that in some cases the split announcement is being timed relative to the grant.

OK but so what?

On average, by granting before the split, a CEO will see his/her wealth increase by more than $450,000!   This is based on the size of the grant and the effect that a 3% stock price increase has on the value of the option.

In case you are wondering, CEOs also appear to time their stock trades relative to split announcements.

These findings are forthcoming in the Journal of Accounting and Economics in the following paper:

“CEO Opportunism?: Option Grants and Stock Trades around Stock Splits” 
Erik Devos, William Elliott, Richard S. Warr
Forthcoming: Journal of Accounting and Economics.

A copy is available for download on my website.