Executive Exercise Explained: Patterns for Stock Options

It is well documented that executives granted stock options tend to exercise early and in a few large transactions or “blocks”. Standard risk-neutral valuation models cannot explain these patterns, and attempts to capture the exercise behavior of risk averse executives have been limited to the special case of one option. This paper solves for the optimal exercise behavior for a risk averse executive who is granted multiple stock options. We show that traditional utility-based models do not predict block exercise behavior. Rather, the risk averse executive exercises stock options individually at a sequence of increasing price thresholds. We give these thresholds in closed form. When, in addition, the executive exerts costly effort to exercise options, he faces a trade-off between exercising little and often to maximize return, and exercising larger quantities on fewer occasions to minimize effort. We find that as costs increase, options are exercised on fewer dates. The costly exercise utility-based model generates block exercise behavior and yields new predictions. In particular, executives should begin by exercising large blocks of options, but the block sizes should become smaller over time.