how to value employee stock options one of the arguments often used against expensing employee stock options is that calculating their fair value at the time they are granted is very difficult this article presents an approach to calculating the value of employee stock options that is practical easy to implement and theoretically sound it explicitly considers the vesting period the possibility that employees will leave the company during the life of the option the inability of employees to trade their options and the relevant dilution issues this approach is an enhancement of the approach suggested by the financial accounting standards board s statement of financial accounting standards no 123 because it does not require an arbitrary reduction in the life of the option to allow for early exercise caused by the inability of employees to trade their options

using auctions to price employee stock options the case of zions bancorporation esoars the first empirical analysis of zions bancorporation s 2006 and 2007 auctions of employee stock option appreciation rights securities esoars this study examined 1 the impact of auction rules on bidding strategies and allocations 2 the efficiency of the auction clearing prices and 3 the value gap between esoars auction clearing prices and various model based estimates it found that the design features of the auctions e g ending rules significantly affected bidding strategies but not final allocations which remained highly concentrated it also found that the clearing prices 1 displayed high price elasticities of demand suggesting efficient price discovery and 2 were low relative to some but not all model based estimates these findings suggest design improvements that might benefit auctions of other illiquid derivatives e g banks troubled assets currently being considered by the u s government

psychological factors and stock option exercise we investigate stock option exercise decisions by over 50 000 employees at seven corporations controlling for economic factors psychological factors influence exercise consistent with psychological models of beliefs employees exercise in response to stock price trends exercise is positively related to stock returns during the preceding month and negatively related to returns over longer horizons consistent with psychological models of values that include reference points employee exercise activity roughly doubles when the stock price exceeds the maximum price attained during the previous year

exercise behavior valuation and the incentive effects of employee stock options abstract we use a large database on eso exercises to document characteristics of exercise behavior and calibrate a utility based model for measuring how differences in exercise behavior are manifested in option values and incentives option values and incentives computed from the model calibrations are compared to those computed from models used to value tradable options our analysis provides guidance to both academics and practitioners about how differences in exercise behavior and model choice affect measures of eso values and incentives and underscores the importance of gaining a thorough understanding of the underlying economic forces that affect the behavior of eso holders

the subjective and objective evaluation of incentive stock options owners of incentive options invariably hold undiversified portfolios this paper derives a model for the subjective and objective values of such options the subjective value the value to the holder is less than the market value because the option is held in an undiversified portfolio and because it is exercised suboptimally from the market perspective the objective value is the cost to the firm of issuing the option and lies between the market and subjective values this value recognizes the suboptimal exercise but not the undiversified discount the model which is the black scholes model with modified parameters is simple to use

backdating executive stock options an ex ante valuation abstract when backdating executive stock options esos the exercise price is set in favor of the recipient executive relative to a non backdated benchmark we find an ex ante upper bound for the cost of backdating to shrink from 10 to about 3 7 as a consequence of the regime change represented by the sarbanes oxley act sox we frame the backdating behavior as a compound exotic option considering both simple and extended models of the underlying eso in the latter case we draw on the analytical eso models of sircar and xiong 2007 post sox we use a longstaff schwartz inspired least squares monte carlo approach

too much pay performance sensitivity abstract we examine the relation between pay performance sensitivity pps the convexity of managerial compensation vega and future stock risk and returns for a large sample of firms between 1992 and 2004 higher pps and vega are both associated with lower future stock returns part of this negative relation can be explained by risk averse managers decreasing equity risk in response to increases in pps and vega however even after correcting for lower future risk future stock returns are negatively associated with the magnitude of option sensitivity this finding is consistent with previous studies that link high option compensation to manager owner agency problems

employee stock option valuation with an early exercise boundary many companies are recognizing that the black scholes formula is inappropriate for employee stock options esos and are moving toward lattice models for accounting or decision making purposes in the most influential of these models the assumption is that employees exercise voluntarily when the stock price reaches a fixed multiple of the strike price effectively introducing a horizontal exercise boundary into the lattice in practice however employees make a trade off between intrinsic value captured and the opportunity cost of time value forgone the model proposed here explicitly recognizes and accounts for this reality and is intuitively appealing easily implemented and compliant with u s accounting standards

revisiting the incentive effects of executive stock options abstract we develop a multiperiod framework to evaluate the incentive effects of executive stock options esos for a given increase in the grant date firm stock price and a concurrent increase in return volatility the increment of total value at the vesting date acts as a proxy for the incentive effects of esos if the option is attached to the existing contract without adjusting cash compensation we suggest that a firm should not always fix the strike price to the grant date stock price instead the strike price should vary with the length of the vesting period we also show that compared with at the money options restricted stock generates greater incentives to increase stock prices in some scenarios especially when equity based awards are vested early if the vesting period is long the firm could grant options instead of restricted stock to maximize incentives

letter from the editor in chief exit stage left contains six articles and two research notes several of the papers offer new insights on research methods and metrics in international business ib studies beugelsdijk hennart slangen and smeets demonstrate and explain why fdi stocks are a biased measure of mne affiliate activity a new metric to measuring crossborder distance is proposed by berry guillen and zhou jensen li and rahman critique the proxies developed from cross national firm level surveys of corruption how political connections can create problems for the accuracy of analysts forecasts in countries varying in their levels of public corruption is examined by chen ding and kim blomkvist kappen and zander explore the innovation creating role played by foreign subsidiaries within the multinational s network li and li use real options theory to explore the tradeoffs between flexibility and commitment in mode of entry strategies the issue concludes with two research notes gao and pan examine the dynamic process of sequential entries ellis wraps up the issue by returning to the general theme of research methods and metrics in ib reseach with an analysis of the importance of effect sizes and a call for authors to evaluate the substantive as well as the statistical significance of their ib research

optimal exercise of executive stock options and implications for firm cost this paper conducts a comprehensive study of the optimal exercise policy for an executive stock option and its implications for option cost average life and alternative valuation concepts the paper is the first to provide analytical results for an executive with general concave utility wealthier or less risk averse executives exercise later and create greater option cost however option cost can decline with volatility we show when there exists a single exercise boundary yet demonstrate the possibility of a split continuation region we also show that for constant relative risk averse utility the option value does not converge to the black and scholes value as the correlation between the stock and the market portfolio converges to one we compare our model s option cost with the modified black and scholes approximation typically used in practice and show that the approximation error can be large or small positive or negative depending on firm characteristics

risk ambiguity and the exercise of employee stock options abstract we investigate the importance of ambiguity or knightian uncertainty in executives stock option exercise decisions we develop an empirical estimate of ambiguity and include it in regression models alongside the traditional measure of risk equity volatility we show that each variable has a significant effect on the timing of option exercises with volatility causing executives to hold options longer to preserve option value and ambiguity increasing the tendency for executives to exercise early

money activity and prices abstract the paper explores the relationships between monetary variables and real economic activity and prices in the six largest industrialized economies univariate and multivariate time series forecasting models are used to break down monetary policy variables into anticipated and unanticipated components overall monetary policy variables particularly domestic credit expansion appear to be significant leading indicators for subsequent real economic activity and prices additionally anticipated components of monetary policy are shown to have as much forecasting ability for subsequently realized economic variables as unanticipated components this does not appear to be consistent with the implications of pure rational expectations models it was also noted that results differed significantly according to the choice of monetary variable and across individual countries in particular the results implied no contradiction with previous findings for the impact of unanticipated money supply in the u s though such contradictions would have appeared if dce had been used as the monetary variable

non marketability and the value of employee stock options abstract we adapt the benninga et al 2005 framework to value employee stock options esos the model quantifies non diversification effects is computationally simple and provides an endogenous explanation of eso early exercise using a proprietary dataset of eso exercise events we measure the non marketability eso discount we find that the eso value on the grant date is approximately 45 of a similar plain vanilla black scholes value the model is aligned with empirical findings of esos gives an exercise boundary of esos and can serve as an approximation to the fair value estimation of share based employee and executive compensation using the model we give a numerical measure of non diversification in an imperfect market

the sensitivity of ceo wealth to equity risk an analysis of the magnitude and determinants abstract to control risk related incentive problems equity holders are expected to manage both the convexity and slope of the relation between firm performance and managers wealth i find stock options but not common stockholdings significantly increase the sensitivity of ceos wealth to equity risk cross sectionally this sensitivity is positively related to firms investment opportunities this result is consistent with managers receiving incentives to invest in risky projects when the potential loss from underinvestment in valuable risk increasing projects is greatest firms stock return volatility is positively related to the convexity provided to managers suggesting convex incentive schemes influence investing and financing decisions

managerial responses to incentives control of firm risk derivative pricing implications and outside wealth management a b s t r a c t we model a firm s value process controlled by a manager maximizing expected utility from restricted shares and employee stock options the manager also controls allocation of his outside wealth which allows partially hedging of his exposure to firm risk managerial control increases the expected time to exercise for his employee stock options it also reduces the gap between his certainty equivalent and the firm s fair value for his compensation but that gap remains substantial managerial control also causes traded options to exhibit an implied volatility smile with costly control the same basic patterns remain but the manager s risk taking is dampened

the exercise and valuation of executive stock options abstract in theory hedging restrictions faced by managers make executive stock options more difficult to value than ordinary options because they imply that exercise policies of managers depend on their preferences and endowments using data on option exercises from 40 firms this paper shows that a simple extension of the ordinary american option model which introduces random exogenous exercise and forfeiture predicts actual exercise times and payoffs just as well as an elaborate utility maximizing model that explicitly accounts for the nontransferability of options the simpler model could therefore be more useful than the preference based model for valuing executive options in practice

does stock return predictability affect eso fair value abstract executive stock options esos are modified american options that cannot be valued using standard methods with a few exceptions the literature has discussed the eso fair value by assuming unpredictable stock returns which are not supported by the available empirical evidence in this paper we obtain the fair value of american esos when stock returns are predictable and specifically driven by the trending ornstein uhlenbeck process of lo and wang 1995 we solve the executive s portfolio allocation problem for a simple buy and hold strategy when his wealth can be distributed between a risk free asset and a market portfolio this problem is jointly solved with the executive s optimal exercise policy we find that executives tend to wait longer the higher the predictability independently of the composition of executive s asset menu we have also analyzed the implications under the fas123r proposals for the eso fair value and found that even for low autocorrelations there is a meaningful mispricing when unpredictable returns are erroneously assumed

structural models and endogeneity in corporate finance the link between managerial ownership and corporate performance this paper presents a parsimonious structural model that isolates primary economic determinants of the level and dispersion of managerial ownership firm scale and performance and the empirical associations among them in particular variation across firms and through time of estimated productivity parameters for physical assets and managerial input and corresponding variation in optimal compensation contract and firm size combine to deliver the well known hump shaped relation between tobin s q and managerial ownership to assess the effectiveness of standard econometric approaches to the endogeneity problem we apply those remedies to panel data generated from the model the unfortunate conclusion is that at least in the ownership performance context proxy variables fixed effects and instrumental variables do not generally provide reliable solutions to simultaneity bias

are ceos really paid like bureaucrats a common view is that there is little correlation between firm performance and ceo pay using a new fifteen year panel data set of ceos in the largest publicly traded u s companies we document a strong relationship between firm performance and ceo compensation this relationship is generated almost entirely by changes in the value of ceo holdings of stock and stock options in addition we show that both the level of ceo compensation and the sensitivity of compensation to firm performance have risen dramatically since 1980 largely because of increases in stock option grants

pricing executive stock options under employment shocks abstract we obtain explicit expressions for the subjective objective and market value of perpetual executive stock options esos under exogenous employment shocks driven by an independent poisson process previously we obtain the executive s optimal exercise policy from the subjective valuation that is necessary for the objective one or fair value the perpetual eso is compared with the true finite maturity eso finding that the approximation is reasonably good to illustrate the usefulness of the objective valuation for accounting purposes we analyze the statistical distribution of the fair value when there is uncertainty about the employment shock intensity finally the role of esos in the design of executives incentives is also discussed

moving closer to the action examining compensation design effects on firm risk we examine the influence of ceo equity based compensation on strategic risk taking by the firm building off the behavioral agency model agency theory and prospect theory we develop arguments about when equity based compensation elements will increase or decrease executive risk propensity and in turn strategic risk taking incorporating a behavioral perspective into our models of incentive alignment provides us with new and potentially more accurate predictions about how individual elements of ceo pay will influence risk selection as well as how equity compensation interacts with cash compensation and with other factors to influence risk preferences in general this study provides evidence that ceo equity based compensation significantly influences strategic risk but that this influence is more nuanced and complex than conventional treatments of executive compensation assume in particular we find that different forms of equity based pay exhibit dissimilar influences on strategic risk and that their influence changes as their value and vesting status change second we find that cash based forms of pay moderate the incentive properties of equity based pay indicating that cash based pay may affect how executives perceive risks associated with equity pay finally we find that stock price volatility and board actions each also moderate the incentive effects of equity based pay in sum our results argue for increased recognition of a behavioral perspective on executive compensation and greater precision in how we measure and model the incentive alignment properties of ceo compensation

american garch employee stock option valuation abstract we implement a flexible simulation based approach for the fair value of employee stock option eso that accounts for the vesting period departure risk and voluntary suboptimal early exercise we introduce garch effects on the underlying asset and we analyze the price bias with respect to the constant volatility case we also perform a sensitivity analysis with respect to changes in several eso characteristics we compare this valuation with fas 123 method revealing a fas overvaluation finally we value a real eso plan providing the confidence intervals for the estimated eso prices

uncertainty avoidance and the timing of employee stock option exercise we examine the impact of the cultural norm of uncertainty avoidance on employee stock option eso exercise behavior using proprietary data from a multinational firm we find that employees from countries with higher levels of uncertainty avoidance exercise their stock options earlier these findings lend support to a maintained assumption in the eso literature that employee attitudes toward uncertainty influence stock option exercise behaviors our findings further help to explain prior findings of cross cultural differences in firms compensation practices by indicating that employee responses to option based pay and firms consequent financial reporting costs vary as functions of employee uncertainty avoidance

what happens when you tax the rich evidence from executive compensation this paper examines the responsiveness of taxable income to changes in marginal tax rates using detailed compensation data on several thousand corporate executives from 1991 to 1995 the data confirm that the higher marginal rates of 1993 led to a significant decline in taxable income indeed this small group of executives may account for as much as 20 percent of the aggregate change in wage and salary income for approximately the one million richest taxpayers over this time period one person alone can account for more than 2 percent the decline however is almost entirely a short run shift in the timing of compensation rather than a permanent reduction in taxable income the short run elasticity of taxable income with respect to the net of tax share exceeds one in this sample but the elasticity after one year is at most 0 4 and probably closer to zero breaking out the tax responsiveness of different types of compensation shows that the large short run responses come almost entirely from a large inc

estimating the value of employee stock option portfolios and their sensitivities to price and volatility the costs associated with compiling data on employee stock option portfolios is a substantial obstacle in investigating the impact of stock options on managerial incentives accounting choice financing decisions and the valuation of equity we present an accurate method of estimating option portfolio value and the sensitivities of option portfolio value to stock price and stock return volatility that is easily implemented using data from only the current year s proxy statement or annual report this method can be applied to either executive stock option portfolios or to firm wide option plans in broad samples of actual and simulated ceo option portfolios we show that these proxies capture more than 99 of the variation in option portfolio value and sensitivities sensitivity analysis indicates that the degree of bias in these proxies varies with option portfolio characteristics and is most severe in samples of ceos with a large proportion of out of the money options however the proxies explanatory power remains above 95 in all subsamples

employee stock option exercises an empirical analysis this paper describes the exercise behavior of over 50 000 employees who hold longterm options on employer stock at eight corporations employees typically exercise options years before expiration commonly sacrificing half of the black scholes value exercise is strongly associated with recent stock price movements the market to strike ratio proximity to vesting dates time to maturity volatility and the employee s level within the company these findings have implications for compensation planners the fasb as it develops a new accounting standard for options and financial statement users and preparers who apply and interpret the new fasb standard

private information in executive stock option trades evidence of insider trading in the uk uk executives stock option exercises and associated sell decisions are motivated by private inside information executives use their inside information to lock in short term gains and to sell stock acquired prior to negative abnormal stock returns this informed trading is robust to the alternative factors that might motivate the exercise of executive stock options including option moneyness and value of exercise we suggest that the disparity in informed trading between us and uk executives option trades is related to important differences in the proportion of executive remuneration linked to options the regulation of options and the taxation of option gains

probability weighting and employee stock options this paper documents that riskier firms with higher idiosyncratic volatility grant more stock options to nonexecutive employees standard models in the literature cannot easily explain this pattern a model in which a risk neutral firm and an employee with prospect theory preferences bargain over the employee s pay package can the key feature which makes stock options attractive is probability weighting the model fits the data on option grants well when calibrated using standard parameters from the experimental literature the results are the first evidence that risky firms can profitably use stock options to cater to an employee demand for long shot bets

managerial optimism and earnings smoothing abstract this paper empirically examines how ceo optimism affects earnings smoothing and earnings surprises the main finding is that optimistic managers smooth earnings more than rational managers and are associated with smaller in absolute value earnings surprises a possible theoretical explanation is offered for these results based on a combination of the torpedo effect the innate behavior of optimists and the risk of litigation prosecution for over reporting earnings

the risk preferences of u s executives in this paper i elicit risk attitudes of u s executives by calibrating a subjective option valuation model for option exercising data 1996 to 2008 yielding approximately 65 000 values of relative risk aversion rra for almost 7 000 executives the observed behavior is generally consistent with moderate risk aversion and a median mean rra close to one three values are validated for chief executive officers ceos by testing theory based predictions on the influence of individual characteristics on risk preferences such as gender marital status religiosity and intelligence senior managers such as ceos presidents and chairpersons of the boards of directors are significantly less risk averse than non senior executives rra heterogeneity is strongly correlated with sector membership and firm level variables such as size performance and capital structure alternative factors influencing option exercises are tested for their influence on rra values this paper was accepted by brad barber finance

does option compensation increase managerial risk appetite this paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls under the manager s optimal policy the option ends up either deep in or deep out of the money as the asset value goes to zero volatility goes to infinity however the option compensation does not strictly lead to greater risk seeking sometimes the manager s optimal volatility is less with the option than it would be if he were trading his own account furthermore giving the manager more options causes him to reduce volatility managers with convex compensation schemes play an important role in financial markets this paper solves for the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls the paper focuses on how the option compensation impacts the manager s appetite for risk when he cannot hedge the option position on one hand the convexity of the option makes the manager shun payoffs that are likely to be near the money under the optimal policy the manager either significantly outperforms his benchmark or else incurs severe losses furthermore in examples of optimal trading strategies asset volatility goes to infinity as asset value goes to zero yet option compensation does not strictly lead to greater risk seeking as asset value grows large or if the evaluation date is far away the manager moderates asset risk for example if the manager has constant relative risk aversion crra asset volatility converges to the merton constant as asset value goes to infinity in some situations the manager actually chooses a lower asset volatility than he would if he were investing on his own because the leverage inherent in his option magnifies his exposure to the asset volatility in addition with all constant or decreasing absolute risk averse utility functions from the hyperbolic absolute risk averse hara class giving the manager more options causes him to reduce asset volatility in the crra case for example the manager targets a fixed volatility for his personal

ceo stock based compensation an empirical analysis of incentive intensity relative mix and economic determinants the use of stock based compensation for u s ceos has increased significantly throughout the 1990s research interest in particular on stock option compensation has similarly increased yet contradictory results create questions about the theoretical underpinnings therefore we revisit the controversy surrounding stock option awards and we further the understanding of restricted stock grants which have escaped similar research focus using a recent data set we obtain convincing empirical support for most theoretical predictions about stock option awards we also find that restricted stock due to its linear payoffs is relatively inefficient in inducing risk averse ceos to accept risky value increasing investment projects copyright 2000 by university of chicago press