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This paper examines how stock options affect the decision to repurchase shares. Firms announce repurchases when executives have large numbers of options outstanding and when employees have large numbers of options currently exercisable. Once the decision to repurchase is made, the amount repurchased is positively related to total options exercisable by all employees but independent of managerial options. These results are consistent with managers repurchasing both to maximize their own wealth and to fund employee stock option exercises. The market appears to recognize this motive, however, and reacts less positively to repurchases announced by firms with high levels of nonmanagerial options.

Early studies of open market stock repurchases document positive abnormal returns of 3–4% at the announcement (Vermaelen, 1981; Dann, 1981). The two most commonly accepted interpretations of this reaction are the signaling theory and the free cash flow theory. The signaling theory posits that the repurchase constitutes a revelation by management of favorable new information about the value of the firm's future prospects. Several empirical studies find evidence consistent with this theory. Comment and Jarrell (1991) find that the announcement-day return is positively associated with the percent of outstanding shares repurchased and negatively associated with the firm's recent stock returns. Ikenberry et al. (1995) examine the long-run performance of companies following open market repurchases, and find that firms that are more likely to be repurchasing shares because of undervaluation exhibit positive abnormal returns of 45.3% in the four years after the announcement. Further support for the signaling theory comes from the companies themselves, who often cite ‘undervaluation’ as the motive for their open market repurchases (The Wall Street Journal, April 1, 1998, p. T2, and Sept. 9, 1998, p. NE2).

I study open market share repurchases from 1993–1996 to examine the effect of total and executive options on the firm's decision to repurchase stock, the actual repurchases made, and on the initial market reaction to the announcement of an open market repurchase program. Previous studies have found that repurchase programs are undertaken both to signal undervaluation to investors and to return free cash flow to shareholders. However, these theories do not explain the sudden and drastic increase in repurchases in the 1990s. One possible explanation for the increased popularity of stock options is the concurrent increase in the use of stock options to compensate not just management but all employees in a firm.