Non-Transferable Non-Hedgeable Executive Stock Option Pricing

49 Pages Posted: 5 Jun 2014 Last revised: 19 Feb 2015

See all articles by David B. Colwell

David B. Colwell

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

David Feldman

Banking and Finance, UNSW Business School, UNSW Sydney; Financial Research Network (FIRN)

Wei Hu

Curtin University - Department of Finance and Banking

Date Written: January 30, 2015

Abstract

To value non-transferable non-hedgeable (NTNH) contingent claims and price executive stock options (ESOs), we use a replication argument to translate portfolios with NTNH derivatives into portfolios of primary assets (only) with stochastic portfolio constraints. By identifying stochastic discount factors and finding subjective prices of NTNH European and American ESOs, for block and continuous partial exercise, we derive executives’ optimal exercise policies, and use these to find objective prices/costs of ESOs to firms. Through numerical simulations, we obtain policy implications regarding ESOs’ incentivizing efficiency. For the first time, we demonstrate that, unlike under block exercise, subjective prices under continuous partial exercise may be higher than objective ones. Moreover, volatility regimes and executives’ “other wealth” are important in ESO pricing, and are thus essential to empirical executive compensation studies.

Keywords: Executive Stock Options, Constrained Portfolio Optimization, Stochastic Discount Factor, Non-Hedgeable, Non-Transferable

JEL Classification: G11, G13, C02, C61

Suggested Citation

Colwell, David B. and Feldman, David and Hu, Wei, Non-Transferable Non-Hedgeable Executive Stock Option Pricing (January 30, 2015). FIRN Research Paper. Available at SSRN: https://ssrn.com/abstract=2446385 or http://dx.doi.org/10.2139/ssrn.2446385

David B. Colwell

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+61 (2) 9385 5851 (Phone)
+61 (2) 9385 6347 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

David Feldman

Banking and Finance, UNSW Business School, UNSW Sydney ( email )

UNSW Sydney, NSW 2052
Australia
+61 2 9385 5748 (Phone)
+61 2 9385 6347 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Wei Hu (Contact Author)

Curtin University - Department of Finance and Banking ( email )

Bentley 6102 WA
Australia

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