Non-Transferable Non-Hedgeable Executive Stock Option Pricing
49 Pages Posted: 5 Jun 2014 Last revised: 19 Feb 2015
Date Written: January 30, 2015
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: Suggested Citation