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Valuing Employee Stock Options: Implications for the Implementation of NZ IFRS 2+

Valuing Employee Stock Options: Implications for the Implementation of NZ IFRS 2+ From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are unconstrained in their portfolio choices and thus are indifferent to the specific risk of any firm. By contrast, ESO holders are frequently required to hold portfolios that are over‐exposed to the firm that employs them and so adopt exercise policies that reflect their individual risk preferences. Applying the model of Ingersoll (2006) to hypothetical ESOs, we show that ESO cost can be extremely sensitive to employee characteristics of risk aversion and under‐diversification. This result casts doubt on the usefulness of any market‐based model for pricing ESOs, since such models, by definition, produce option values that are independent of employee characteristics. By limiting employee discretion over the choice of exercise date, vesting restrictions help reduce the magnitude of this problem. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Pacific Accounting Review Emerald Publishing

Valuing Employee Stock Options: Implications for the Implementation of NZ IFRS 2+

Pacific Accounting Review , Volume 18 (1): 18 – Mar 1, 2006

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Publisher
Emerald Publishing
Copyright
Copyright © 2006 Emerald Group Publishing Limited. All rights reserved.
ISSN
0114-0582
DOI
10.1108/01140580610732750
Publisher site
See Article on Publisher Site

Abstract

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are unconstrained in their portfolio choices and thus are indifferent to the specific risk of any firm. By contrast, ESO holders are frequently required to hold portfolios that are over‐exposed to the firm that employs them and so adopt exercise policies that reflect their individual risk preferences. Applying the model of Ingersoll (2006) to hypothetical ESOs, we show that ESO cost can be extremely sensitive to employee characteristics of risk aversion and under‐diversification. This result casts doubt on the usefulness of any market‐based model for pricing ESOs, since such models, by definition, produce option values that are independent of employee characteristics. By limiting employee discretion over the choice of exercise date, vesting restrictions help reduce the magnitude of this problem.

Journal

Pacific Accounting ReviewEmerald Publishing

Published: Mar 1, 2006

Keywords: New Zealand; Stock options; Modelling

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