Timing of Employee Stock Option Exercises and the Cost of Stock Option Grants

49 Pages Posted: 1 Jun 2006 Last revised: 4 Apr 2012

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Alan D. Jagolinzer

University of Cambridge Judge Business School

David F. Larcker

Stanford University - Graduate School of Business

Date Written: June 1, 2007

Abstract

This study examines how executives' and lower-level employees' option exercise behavior affects firms' stock option grant cost estimates. Prior research suggests that option grant cost estimates are not materially different when calculated a using utility-based model or a risk-neutral model adjusted for historical exercise rates. This study shows, however, that estimates of exercise times are significantly improved when the model accounts for behavioral and economic determinants of option exercise such as the attainment of performance benchmarks, recent vesting, the intrinsic value of an employee's option portfolio, and employee rank. Hazard analysis of all executive and employee option grants within a proprietary sample of firms yields lower out-of-sample exercise timing prediction errors relative to utility-based models and estimates using historical exercise patterns. More importantly, option cost estimates are materially different when improved estimates of exercise times are used, which may have implications for financial reporting.

Keywords: Option expense, employee option exercise, SFAS 123, stock option cost, survival analysis

JEL Classification: C34, C41, J33, M52

Suggested Citation

Armstrong, Chris S. and Jagolinzer, Alan D. and Larcker, David F., Timing of Employee Stock Option Exercises and the Cost of Stock Option Grants (June 1, 2007). Rock Center for Corporate Governance Working Paper No. 34. Available at SSRN: https://ssrn.com/abstract=905280 or http://dx.doi.org/10.2139/ssrn.905280

Chris S. Armstrong

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Alan D. Jagolinzer

University of Cambridge Judge Business School ( email )

Trumpington Street
University of Cambridge
Cambridge, CB2 1AG
United Kingdom

David F. Larcker (Contact Author)

Stanford University - Graduate School of Business ( email )

Graduate School of Business
518 Memorial Way
Stanford, CA 94305-5015
United States
650-725-6159 (Phone)

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