The Valuation and Exercise of Executive Stock Options

Abstract

Much has been made of the potential for hedging restrictions to reduce the value of executive stock options. We investigate this issue by comparing a rational utility-maximizing model that incorporates both hedging restrictions and an endogenous departure decision and a naïve value-maximizing model with an exogenous departure rate. While researchers mainly use these kinds of models to compute option values, we also use the models to generate forecasts of observable variables, the size and the timing of the payoffs of exercised options, and the annual rate at which options are canceled. We show that the naïve model provides just as good a description of actual exercise patterns of executives as the rational model in a sample of NYSE and AMEX firms. The more parsimonious naïve model may, there, be better for the purpose of valuation. The naïve incorporation of the exogenous departure rate in the standard America option model not only aligns predicted exercise and cancellation patterns with actual patterns, but also reduces option value by about a quarter.