Stock Option Expense, Forward-Looking Information, and Implied Volatilities of Traded Options

37 Pages Posted: 8 Oct 2008

See all articles by Eli Bartov

Eli Bartov

NYU Stern School of Business

Partha S. Mohanram

Rotman School of Management, University of Toronto

Doron Nissim

Columbia University - Columbia Business School

Multiple version iconThere are 2 versions of this paper

Date Written: April 2004

Abstract

Prior research generally finds that firms underreport option expense by managingassumptions underlying option valuation (e.g. they shorten the expected option lives), but it fails to document management of a key assumption, the one concerning expected stock-price volatility. Using a new methodology, we address two questions: (1) To what extent do companies follow the guidance in FAS 123 and use forward looking information in addition to the readily available historical volatility in estimating expected volatility? (2) What determinesthe cross-sectional variation in the reliance on forward looking information? We find that firms use both historical and forward-looking information in deriving expected volatility. We also find, however, that the reliance on forward-looking information is limited to situations where this reliance results in reduced expected volatility and thus smaller option expense. We interpret this finding as managers opportunistically use the discretion in estimating expected volatility afforded by FAS 123. In support of this interpretation, we also find that managerial incentivesplay a key role in this opportunism.

Keywords: executive stock options, forward-looking information, SFAS No. 123, implied volatility

Suggested Citation

Bartov, Eli and Mohanram, Partha S. and Nissim, Doron, Stock Option Expense, Forward-Looking Information, and Implied Volatilities of Traded Options (April 2004). NYU Working Paper No. 2451/27569, Available at SSRN: https://ssrn.com/abstract=1280732

Eli Bartov (Contact Author)

NYU Stern School of Business ( email )

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New York, NY 10012
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212.998.0016 (Phone)

Partha S. Mohanram

Rotman School of Management, University of Toronto ( email )

Canada

Doron Nissim

Columbia University - Columbia Business School ( email )

NY
United States
212-854-4249 (Phone)

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