Employee Stock Options: Much More Valuable than You Thought

31 Pages Posted: 8 Dec 2004

See all articles by James E. Hodder

James E. Hodder

Wisconsin School of Business

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Date Written: March 1, 2005


Previous papers have argued that trading restrictions can result in a typical employee stock option having a subjective value (certainty equivalent value) that is substantially less than its Black-Scholes value. However, these analyses ignore the manager's ability to (at least partially) control the risk level within the firm. In this paper, we show how managerial control can lead to such options having much larger certainty equivalent values for employees who can exercise control. We also show that the potential for early exercise is substantially less valuable with managerial control.

The certainty equivalent value for a European option with managerial control can easily exceed the Black-Scholes value for a comparable option without control. However, it is questionable whether Black-Scholes is an appropriate benchmark for an option where the underlying process exhibits controlled volatility. We show how to obtain a risk-neutral valuation for such an option. That risk-neutral value can be substantially greater or less than the Black-Scholes value. Furthermore, the option's certainty equivalent value can also be greater or less than its risk-neutral value.

Keywords: Employee Stock Options, Dynamic Optimatimization

JEL Classification: G13, G34

Suggested Citation

Hodder, James Ernest and Jackwerth, Jens Carsten, Employee Stock Options: Much More Valuable than You Thought (March 1, 2005). Available at SSRN: https://ssrn.com/abstract=601624 or http://dx.doi.org/10.2139/ssrn.601624

James Ernest Hodder

Wisconsin School of Business ( email )

975 University Avenue
Madison, WI 53706
United States
608-262-8774 (Phone)
608-263-0477 (Fax)

Jens Carsten Jackwerth (Contact Author)

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

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