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Reviews previous research on the timing of employee stock option exercise decisions and share price performance before and after insider trading. Analyses the 1992‐1993 exercise behaviour of top executives at 65 large US firms using the Black‐Scholes (1973) value (less anticipated dividends) as a benchmark to compare with the intrinsic value (market price minus exercise price) at the date of exercise. Finds options are exercised when the two values are roughly equal, i.e. that executives’ decisions are not risk‐averse or biased by private information. Also shows a tendency for the subsequent change in share prices to be lower when the intrinsic value is less than the Black‐Scholes value at the time of exercise. Considers consistency with other research and the implications of the findings.

An option is a contract between two parties by which party A grants party B the right to buy from or sell to A, at B's discretion, a given asset at a fixed price until a fixed date after which any rights or obligations expire. The party having the discretionary right to buy or sell is the buyer of the option (in this case, B), and the party granting the right is the seller, or writer, of the option. An option to buy is known as a call option, and an option to sell as a put option. The fixed price specified in the option contract is termed the exercise or striking price, and the fixed date the expiration date. A European option is one which can only be exercised on the date when the option expires; an American option can be exercised at any time up to and including the expiration date. Though there are many different types of underlying asset on which an option could be based, it is options written on ordinary shares quoted on the Stock Market which have been of most interest. This has been greatly enhanced in recent years by the creation of organised markets for options in the main financial centres of the world. The first part of this paper considers the practical aspects of options and the main features of an organised options exchange. The second part of the paper concentrates on introducing option pricing theory in a simplified form. Finally, some of the many and varied possible applications of options and option pricing theory are briefly reviewed.

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.

More than 80 percent of S&P 500 firms that issue ESOs use the Black-Scholes-Merton (BSM) model and substitute the estimated average term for the contractual expiration to calculate ESO expense. This simplification systematically overprices ESOs, which worsens as the stock's volatility increases. The purpose of this paper is to present a modification of the BSM model to explicitly incorporate the rates of forfeiture pre- and post-vesting and the rate of early exercise.

The paper demonstrates the model's usefulness by employing historical exercise and forfeiture data for 127 separate ESO grants and 1.31 billion ESOs to calculate the exercise and forfeiture parameters and value ESOs for nine firms.

The modified BSM model is just as accurate but easier to use than the more computationally intensive utility maximization and trinomial lattice models, and it avoids the ASC 718 BSM model's overpricing bias.

If firms prefer the BSM model over more mathematically elegant alternatives, they should at least use a BSM model that is free of overpricing bias.

This paper provides a fuller characterization of the analytical upper bounds for American options than has been available to date. We establish properties required of analytical upper bounds without any direct reliance on the exercise boundary. A class of generalized European claims on the same underlying asset is then proposed as upper bounds. This set contains the existing closed form bounds of Margrabe, (1978) and Chen and Yeh (2002) as special cases and allows randomization of the maturity payoff. Owing to the European nature of the bounds, across-strike arbitrage conditions on option prices seem to carry over to the bounds. Among other things, European option spreads may be viewed as ratio positions on the early exercise option. To tighten the upper bound, we propose a quasi-bound that holds as an upper bound for most situations of interest and seems to offer considerable improvement over the currently available closed form bounds. As an approximation, the discounted value of Chen and Yeh's (2002) bound holds some promise. We also discuss implications for parametric and nonparametric empirical option pricing. Sample option quotes for the European (XEO) and the American (OEX) options on the S&P 100 Index appear well behaved with respect to the upper bound properties but the bid–ask spreads are too wide to permit a synthetic short position in the early exercise option.

The current and widespread view in option trading is that early exercise of call options is suboptimal unless there are large dividend payments on the underlying stock (e.g., Finucane, 1997; Hull, J. C. (2008). Options, futures and other derivatives (7th ed.). Upper Saddle River, NJ: Prentice Hall; Poteshman & Serbin (2003)). Our study substantially refines this view by demonstrating that U.S. tax rules governing capital gain holding periods can create incentives for early exercise under certain conditions. Hence, this study adds to the factors that investors likely consider when making option exercise decisions. We further note that recent research documents early exercises in the absence of large dividends, and refers to these option exercises as “clearly irrational.” Predictions of early exercise from our tax-based model are consistent with the observed patterns of early exercise, suggesting that the criteria for denoting an option exercise as “irrational” should be refined to incorporate capital gain holding periods.

This paper seeks to evaluate the cost of repriceable options, and to investigate whether repriceable employee stock options (ESOs) cost more than standard ESOs in providing incentives to employees.

This paper develops an intensity‐based model, reflecting the special features of repriceable ESOs. The model is used to assess shareholder cost of repriceable ESOs, to explore their early exercise pattern and to compare their incentive effect with standard ESOs.

Two main conclusions arise. First, option holders of repriceable ESOs postpone their exercise before repricing. But, once the exercise price has been reset, option holders are more likely to exercise ESOs early. Second, option repricing is less cost‐effective than standard options in providing incentives.

This research finds that issuing new options proves more efficient than option repricing in providing incentives. In turn, this research offers a practical guideline to companies confronted with underwater options.

Constructing and applying a more accurate valuation model than those previously developed, this paper investigates several important questions about ESOs repricing. Chiefly, this research helps academics and practitioners better understand the cost of repriceable options, how repricing influences employees’ early exercise decisions, and whether option repricing is cost‐effective in providing incentives. These are important questions to ask, filling gaps in the existing literature.

This article investigates the most appropriate accounting treatment for expensing the fair value of employee share options (ESOs) in financial statements. The debate centres around whether the grant date or the exercise date is the most appropriate date for determining the value at which the ESOs are eventually accrued within the financial statements. After examining accounting models for each of the above measurement dates, the article concludes that exercise date accounting best reflects the economic substance of the ESO transaction. Therefore, the IASB should consider revising its definition of equity to encompass only existing shareholders, leaving all other financial obligations to be classified as liabilities.

This exercise exposes students to the accounting for stock option modifications and option service and performance conditions, requiring research in the Financial Accounting Standards Board (FASB) Accounting Standards Codification and the use of the Black-Scholes option pricing model.

Students identify and apply accounting standards to account for stock option plans, stock option modifications, acquired stock option plans, and service and performance conditions that relate to stock option plans. Indirect student feedback suggests that students view the exercise as valuable. Comments include that the exercise reinforces and expands their knowledge of real-world stock compensation plans. Direct assessment data using grading rubrics finds that most students meet instructor expectations.

The exercise enhances critical thinking skills, increases professional research practice, and improves written skills. It introduces students to common real-world events and reinforces their learning related to stock compensation.

This paper analyzes economic, legal, behavioral and public policy issues pertaining to the accounting for employee stock options. The paper explains why employee stock options (ESOs) are superior to other forms of incentive compensation, why ESOs in their present form are inefficient and why particular accounting, legal and tax treatments will provide the optimal results for the economy, the government, management/employees and shareholders. The issues discussed in this article are relevant in ESO accounting, regulation of ESOs, incentive compensation, human resources analysis, tax policy, corporate governance, fraud, valuation of companies, derivatives regulation, behavioral analysis of law/rules, portfolio management and management strategy.