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The Option to repurchase stock

Author: Vermaelen, Theo ; Ikenberry, DINSEAD Area: Finance Series: Working Paper ; 94/73/FIN Publisher: Fontainebleau : INSEAD, 1994.Language: EnglishDescription: 30 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: The signaling hypothesis is often used to explain the market reaction to the announcement of open market share repurchase programmes. Yet these programmes are not firm commitments. Although companies may announce their intention to reacquire shares, repurchase programmes done via the open market, by design, give managers the flexibility to forego repurchasing stock. As such, these programmes may be poor signals, they contain valuable options. The authors model this as an exchange option. Empirical evidence from 892 announcements between 1980 and 1990 is consistent with the predictions of the model. Announcement returns are positively related to the magnitude of the repurchase and to the return volatility of the stock. The average maturity implied by the option is 22 months, a result strikingly similar to what is observed in practice. Perhaps most interestingly, the authors find that, as predicted by the model, announcement returns are negatively related to a proxy for the correlation between the firm's traded price and its "true" price, the difference of which is fundamental to giving value to the option.
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The signaling hypothesis is often used to explain the market reaction to the announcement of open market share repurchase programmes. Yet these programmes are not firm commitments. Although companies may announce their intention to reacquire shares, repurchase programmes done via the open market, by design, give managers the flexibility to forego repurchasing stock. As such, these programmes may be poor signals, they contain valuable options. The authors model this as an exchange option. Empirical evidence from 892 announcements between 1980 and 1990 is consistent with the predictions of the model. Announcement returns are positively related to the magnitude of the repurchase and to the return volatility of the stock. The average maturity implied by the option is 22 months, a result strikingly similar to what is observed in practice. Perhaps most interestingly, the authors find that, as predicted by the model, announcement returns are negatively related to a proxy for the correlation between the firm's traded price and its "true" price, the difference of which is fundamental to giving value to the option.

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