Darryl Laws

 Some CEOs, however, do exactly the opposite. They hold options that are well “in

the money” and buy, rather than sell, company stock. These CEOs bet their personal

wealth on future company stock performance. One way to potentially measure overconfidence, then, is to look at CEOs who hold options beyond rational thresholds. Calibrations of the Hall and Murphy (2002) model (with CRRA utility, risk aversion of 3, and 67% of wealth in company stock) would suggest exercise entering the final year of duration when the option value exceeds 40%. The median option held to expiration is in excess of 200% in the money. Alternatively, we look at a common year beyond the vesting period for all of the options in our sample (year 5). Here, Malmendier and Tate use the Hall and Murphy model to calibrate a range of rational thresholds for exercise (varying risk aversion and diversification). Then, Malmendier and Tate (2005) consider a sub-sample of CEOs with options beyond these benchmarks and compare those CEOs who exercise (rational) to CEOs who continue to hold (overconfident). The sample restriction assures that the measurement does not contaminate the overconfidence measure with CEOs who have not yet had the opportunity to display overconfidence. To check whether these exercise decisions are driven by inside information, they computed the returns CEOs earned as a result of their trading decisions. We find no evidence that CEOs earn abnormal returns by holding options beyond rational benchmarks. Indeed, it appears that CEOs who hold all the way to expiration would have been better off on average by exercising (1, 2, 3, or 4 years) earlier and simply investing the proceeds in the S&P 500.

A second measure, proposed by Malmendier and Tate (2005), builds on the perception of outsiders. They conducted a study which comprised their hand-collecting data on how the press portrays each of the CEOs during a sample period. They search articles referring to the CEOs in The New York Times , Business Week , Financial Times , The Economist  and The Wall Street Journal . For each CEO and sample year, they recorded the number of articles containing the words ‘confident’ or ‘confidence;’ the number of articles containing the words ‘optimistic’ or ‘optimism;’ and the number of articles containing the words ‘reliable’, ‘cautious’, ‘conservative’, ‘practical’, ‘frugal’, or ‘steady’. Then they hand-checked the terms that were used to describe the CEO in question and separate out articles describing the CEO as ‘not confident’ or ‘not optimistic’. They then construct an indicator, TOTAL dummy, equal to 1 if a CEO is more often described as ‘confident’ and ‘optimistic’ or as ‘reliable’, ‘cautious’, ‘conservative’, ‘practical’, ‘frugal’, or ‘steady’. They found that This alternative indicator of CEO confidence is significantly positively correlated with their portfolio measures.

Darryl Laws