Executive Stock and Option Valuation in a Two State-Variable Framework

Jie Cai; Anand Vijh

doi:10.3905/jod.2005.479376

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Executive Stock and Option Valuation in a Two State-Variable Framework

Journal article

Peer reviewed

Executive Stock and Option Valuation in a Two State-Variable Framework

Jie Cai and Anand Vijh

The Journal of derivatives, Vol.12(3), pp.9-27

03/22/2005

DOI: 10.3905/jod.2005.479376

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Abstract

Much has been written about how executive stock options should be valued. The options themselves are not that complicated, but they have a variety of special features that make valuing them difficult, like vesting rules and restrictions on selling them in the market. Forcing the option holder to keep a concentrated position in the firm's equity and options, rather than diversifying into a broader portfolio, lowers the value of the options to the recipient. That, in turn, reduces the performance incentive that option grants are meant to produce, and raises the effective cost to the firm of providing that incentive. The problem is mitigated in many executive stock option valuation models, because they assume that the executive allocates his wealth portfolio between options and/or restricted firm stock, and a risk-free asset. Since there are no other equity instruments in the model, there is an extra demand for the options because they are the way the investor gains access to the equity market. In this article, Cai and Vijh broaden the range of available assets to include the ability to invest outside wealth in the market portfolio. This allows diversification, but more importantly, it provides an alternative vehicle for the executive to capture the stock market risk premium. The overall effect is to lower the option value to the executive. [PUBLICATION ABSTRACT]

Capital assets

Executive compensation

Investments

Models

Portfolio diversification

Portfolio management

Restricted stock

Risk premiums

Securities prices

Stock options

Studies

Valuation

Details

Title: Subtitle: Executive Stock and Option Valuation in a Two State-Variable Framework
Creators: Jie Cai - University of Iowa
Anand Vijh
Resource Type: Journal article
Publication Details: The Journal of derivatives, Vol.12(3), pp.9-27
Publisher: Pageant Media
DOI: 10.3905/jod.2005.479376
ISSN: 1074-1240
eISSN: 2168-8524
Language: English
Date published: 03/22/2005
Academic Unit: Finance
Record Identifier: 9984380475802771

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