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Employee Stock Options: Much More Valuable Than You Thought

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  • Jens Carsten Jackwerth

    ()
    (Department of Economics, University of Konstanz)

  • James E. Hodder

    ()
    (Finance Department, University of Wisconsin-Madison)

Abstract

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.

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Bibliographic Info

Paper provided by Center of Finance and Econometrics, University of Konstanz in its series CoFE Discussion Paper with number 05-01.

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Length: 31 pages
Date of creation: 28 Feb 2005
Date of revision:
Handle: RePEc:knz:cofedp:0501

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  1. Jens Carsten Jackwerth & James Hodder, 2005. "Incentive Contracts and Hedge Fund Management," Working Papers wp05-10, Warwick Business School, Finance Group.
  2. Carpenter, Jennifer N., 1998. "The exercise and valuation of executive stock options," Journal of Financial Economics, Elsevier, vol. 48(2), pages 127-158, May.
  3. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  4. Detemple, Jerome & Sundaresan, Suresh, 1999. "Nontraded Asset Valuation with Portfolio Constraints: A Binomial Approach," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 835-72.
  5. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
  6. Huddart, Steven, 1994. "Employee stock options," Journal of Accounting and Economics, Elsevier, vol. 18(2), pages 207-231, September.
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