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Employee Stock Options: Much More Valuable Than You Thought

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  • Jens Carsten Jackwerth
  • James Hodder

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 Warwick Business School, Finance Group in its series Working Papers with number wp05-09.

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Date of creation: 2005
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Handle: RePEc:wbs:wpaper:wp05-09

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  1. 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.
  2. Hodder, James E. & Jackwerth, Jens Carsten, 2007. "Incentive Contracts and Hedge Fund Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(04), pages 811-826, December.
  3. Huddart, Steven, 1994. "Employee stock options," Journal of Accounting and Economics, Elsevier, vol. 18(2), pages 207-231, September.
  4. Jennifer Carpenter, 1997. "The Exercise and Valuation of Executive Stock Options," New York University, Leonard N. Stern School Finance Department Working Paper Seires 97-10, New York University, Leonard N. Stern School of Business-.
  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. 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.
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