The Effect of Exercise Date Uncertainty on Employee Stock Option Value

30 Pages Posted: 31 Oct 2003

See all articles by Brian A. Maris

Brian A. Maris

Northern Arizona University - College of Business Administration

Jo-Mae Maris

Northern Arizona University - College of Business Administration

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Abstract

The IASC recently recommended that employee compensation in the form of stock options be measured at the 'fair value' based on an option pricing model and the value should be recognized in financial statements. This follows adoption of SFAS No. 123 in the United States, which requires firms to estimate the value of employee stock options using either a Black-Scholes or binomial model. Most US firms used the B-S model for their 1996 financial statements. This study assumes that option life follows a Gamma distribution, allowing the variance of option life to be separate from its expected life. The results indicate the adjusted Black-Scholes model could overvalue employee stock options on the grant date by as much as 72 percent for nondividend paying firms and by as much as 84 percent for dividend paying firms. The results further demonstrate the sensitivity of ESO values to the volatility of the expected option life, a parameter that the B-S model or a Poisson process cannot accommodate. The variability of option life has an especially big impact on ESO value for firms whose ESOs have a relatively short life (5 years, for example) and high employee turnover. For such firms, the results indicate a binomial option pricing model is more appropriate for estimating ESO value than the B-S type model.

JEL Classification: J33, M41, M45, G13

Suggested Citation

Maris, Brian A. and Maris, Jo-Mae and Yang, Tyler T., The Effect of Exercise Date Uncertainty on Employee Stock Option Value. Journal of Business Finance & Accounting, Vol. 30, pp. 669-698, June 2003. Available at SSRN: https://ssrn.com/abstract=443750

Brian A. Maris (Contact Author)

Northern Arizona University - College of Business Administration ( email )

PO Box 15066
Flagstaff, AZ 86011
United States

Jo-Mae Maris

Northern Arizona University - College of Business Administration ( email )

PO Box 15066
Flagstaff, AZ 86011
United States

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

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