A Simple Formula to Calculate the Cost of Executive Stock Options

35 Pages Posted: 7 Mar 2011  

Ashay Kadam

Cass Business School Faculty of Finance

Yan Li

Korea University Business School

Anand Srinivasan

CAFRAL, Reserve Bank of India; National University of Singapore - Department of Finance

Date Written: August 9, 2010

Abstract

We derive a simple formula for the cost of the ESO to the firm at the grant date under the assumption that the executive has a constant market-to-strike multiple. The market-to-strike multiple is defined as the ratio of the market price on exercise to the strike price of the ESO. The expected value of this multiple is the only input that needs to be estimated for calculating ESO cost using our formula (hence-forth, KLS formula). Using a large data set of insider trades, we find that the KLS formula has a lower prediction error relative to the Black-Scholes-Merton (BSM) formula. We also find that the error due to the assumption of a constant market-to-strike multiple is quite small. Further, our model generally leads to negative prediction errors whereas the BSM model generally has positive prediction errors. A composite estimate of ESO costs using the average of both methods (KLS and BSM) proves much better than either method individually.

Keywords: Executive Stock Options, Executive Compensation, Accounting Cost

JEL Classification: C61, G13, G30, J33, M12, M41, M52

Suggested Citation

Kadam, Ashay and Li, Yan and Srinivasan, Anand, A Simple Formula to Calculate the Cost of Executive Stock Options (August 9, 2010). Available at SSRN: https://ssrn.com/abstract=1777038 or http://dx.doi.org/10.2139/ssrn.1777038

Ashay Kadam

Cass Business School Faculty of Finance ( email )

106 Bunhill Row
London, EC1Y 8TZ
Great Britain
+44 20 7040 8632 (Phone)

Yan Li

Korea University Business School ( email )

1 Anam-dong 5 ka
Seoul, 136-701
Korea
82-2-3290-2622 (Phone)

Anand Srinivasan (Contact Author)

CAFRAL, Reserve Bank of India ( email )

Mezzanine Floor, RBI Main Building
Shahid Bhagat Singh Road
Mumbai, Maharashtra 400 001
India

National University of Singapore - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

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