A basic tenet of contracting theory is that risk-averse agents require higher expected returns for taking on more risk. However, this principle appears to be at odds with the modest (i.e., 3%) abnormal returns that undiversified CEOs tend to earn on voluntary purchases of their firm’s stock. In contrast to research that focuses on direct trading profits as the primary motive for CEOs’ purchases, we argue that CEOs can also indirectly benefit from prolonged tenure by purchasing shares of their firm’s stock. By voluntarily purchasing additional shares, CEOs can credibly signal their favorable private information, which informs boards as they decide whether to retain or remove CEOs. We estimate that adding the indirect benefit of prolonged tenure following purchases increases CEOs’ total annual returns from 3% to 58%.
To determine whether purchases of their firm’s stock allow CEOs to prolong their employment, we first consider the characteristics of CEOs who make net purchases (i.e., CEOs whose open market purchases exceed their open market sales during the year). We find that net purchasers typically have had a shorter tenure, oversee firms with greater idiosyncratic volatility, and make their voluntary share purchases after poor stock performance. During periods of poor stock price performance, CEOs’ tend to face a heightened risk of performance-related turnover, which provides an incentive for CEOs to purchase shares to signal their expectation of better future performance to the board and investors. To the extent that CEOs’ purchases are viewed as being personally costly, we expect that investors and boards will perceive their purchases as credible evidence that the CEO possesses favorable private information about future performance. For CEOs, who tend to be highly under-diversified, the opportunity cost of not diversifying investments is significant, and this is especially true for CEOs of firms with high idiosyncratic volatility, making purchases by these CEOs more credible.