Corporate Governance

Security Issue Timing

By Harvard Law School Program on Corporate Governance

In our forthcoming Journal of Finance paper entitled Security Issue Timing: What Do Managers Know, and When Do They Know It?, we complete a large-scale empirical analysis of companies who sell put options on their own stock. A unique feature of our setting is the ability to investigate option exercises and expirations directly. Also, since put sales can be viewed as a levered bet that the stock price will not drop, they offer a unique setting to study market timing by corporations.

We identify firms that sold put options on their own stock by searching annual and quarterly reports available on the Lexis-Nexis, Factiva, and Edgar databases. We eliminate put issues which were sold in conjunction with other equity or debt securities by the same firm, and retain only stand-alone put sales. We match put sellers with data on firm characteristics from Compustat and data on stock returns from CRSP. The final sample contains 137 firms and 802 distinct put issues.

Our tests show that managers are able to identify undervalued equity and successfully time the market with their put option sales. In the 100 trading days following put option issues, there is roughly a 5% abnormal stock return; the results are robust to variations in benchmarks and test methods. Much of the abnormal return follows the first earnings release date after the put sale. This suggests that managers? private information includes ? but is not limited to ? information about one-quarter ahead earnings. No abnormal returns are observed subsequent to quarters in which a firm skips put sales, consistent with timing. Both exercise frequencies and payoffs to option holders are substantially lower than in a matched control sample.

We also find stock return volatility declines after firms? initial put sales. One interpretation is that there is volatility timing by put issuers. Little managerial sophistication is required for such timing to be feasible, and it is not even necessary that managers consciously focus on volatility. It is sufficient, for example, that managers are more likely to sell puts when they perceive the likelihood of extreme news to be lower than outsiders do. Finally, we find no evidence that firms manipulate share prices before put expirations. We do not observe stock price reversals after put options mature and we detect no increase in (potentially manipulative) share repurchases in quarters when puts expire or are exercised.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on December 30, 2009 (boomark / email).