Executive Turnover and the Valuation of Stock Options

Abstract

This paper develops a model for the valuation of executive stock options (ESOs) considering two sources of early exercise: forced exercise due to executive turnover and voluntary exercise due to personal considerations. Using data of about 4,000 US executives, I estimate separate hazard rate factor models for both sources of early exercise. In a second step, I combine both conditional hazard exercise models for the valuation of a representative ESO in a Monte Carlo simulation. Analysis of the individual valuation impact of each source of early exercise shows that turnover induced exercises are responsible for most of the valuation discount of ESOs to market traded options. This result is important as most of the current literature on ESOs concentrates solely on voluntary exercises. I further find that the common practice valuation approach suggested by the Financial Accounting Standards Board (FASB) consistently underestimates ESO values.

Keywords: Executive stock options, executive turnover, early exercise, executive compensation, option valuation

JEL Classification: C15, G30, M52