The Effect of Stock Option Holdings on the Wealth Change in Share Repurchases

of share repurchases have been reported in the area of Corporate Finance (Dann, 1981; Vermaelen, 1981). Explanations for these abnormal returns that have been attempted through many studies include signaling, wealth transfer, and free cash flow hypotheses. Two papers readdress this topic from the unexplored viewpoint. Kahle (2002) found that firms often repurchase their shares in preparation for stock option exercises and that managers who hold stock options tend to prefer share repurchases to dividend payments as a way to maximize their wealth. Maxwell and Stephens (2003) examined changes in both stockholders’ and bondholders’ wealth around the time of share repurchases. Recently, many firms have started to offer stock options to managers as an incentive for them to align their personal gain with firm value maximization. However, it has been also pointed out that such company-wide option plans can cause firms to take risky investments and to pursue short-term profits, which may deepen the possible conflict of interest between stockholders and bondholders. Defusco et al. (1990) tested that the introduction of stock options increases managers’ risk-taking incentive and thus transfers wealth from bondholders to stockholders. The signaling hypothesis on share repurchases posits that both equity and bond returns at the repurchase announcement are positive and, at the same time, their correlation is positive, while the wealth transfer hypothesis is associated with the positive equity, negative bond returns, and a negative correlation. However, considering that stock option holdings provide managers with the incentives to take high-risk projects, I speculate that the announcement of share repurchases in the firm whose managers hold stock options may have different wealth effects on shareholders, bondholders, and managers. To the best of my knowledge, no research has been conducted to study the relation of share repurchases with both stock option holdings and bondholders’ wealth change. Therefore, using the sample of 312 Korean firms, I investigate the effect of executive stock option holdings on the wealth change (of stockholders and bondholders) at the announcement of open market stock repurchases. Specifically, this study is based on the following three researches: (1) Kahle (2002) showed that abnormal stock returns at the repurchase announcement are less positive in the firms in which managers hold stock options, but she didn’t measure bondholders’ wealth change; (2) Defusco et al. (2003) demonstrated that managers who hold stock options prefer risk-taking activities that transfer wealth from bondholders to stockholders, but they didn’t include a specific corporate event such as share repurchases; (3) Maxwell and Stephens (2003) examined the wealth change of both shareholders and bondholders at the announcement of share repurchases, but they didn’t consider stock option holdings. Furthermore, as in Eberhart and Siddique (2002) and Elliott et al. (2005), this study focuses on the correlation between stock and bond returns. First, I divide the total sample into two groups according to whether managers hold stock options or not. Then, I test the signaling and wealth transfer hypotheses associated with share repurchases by measuring the abnormal stock and bond returns and their correlation. And then, controlling for percentage of shares authorized for repurchases, firm size, leverage ratio, market to book ratio, free cash flow, percentage of shares owned by the largest shareholder, and credit rating, I test if the correlation between stock and bond returns still differs by stock option holdings. The empirical analyses show that in the firm whose managers hold stock options, the stockholders’ wealth increases less and bondholders’ wealth even decreases. The correlation between stock and bond returns is positive in the firm whose managers do not hold stock options, which supports the signaling hypothesis. On the other hand, the correlation is negative in the case that managers hold stock options, which is consistent with the wealth transfer hypothesis. These results support the notion that the market recognizes managers’ motive to maximize their own wealth. In addition, the results imply that since the increase in leverage ratio, as a result of share repurchases along with option-holding managers’ risk-taking activities, escalates the risk of firms, the share repurchases may do good to both shareholders and managers but do harm to bondholders.