Stock Option Expense, Forward-Looking Information, and Implied Volatilities of Traded Options

Abstract

Prior research generally finds that firms underreport option expense by managing assumptions underlying option valuation (e.g. they shorten the expected option lives), but it fails to document management of a key assumption, the one concerning expected stock-price volatility. Using a new methodology, we address two questions: (1) To what extent do companies follow the guidance in FAS 123 and use forward looking information in addition to the readily available historical volatility in estimating expected volatility? (2) What determines the cross-sectional variation in the reliance on forward looking information? We find that firms use both historical and forward-looking information in deriving expected volatility. We also find, however, that the reliance on forward-looking information is limited to situations where this reliance results in reduced expected volatility and thus smaller option expense. We interpret this finding as managers opportunistically use the discretion in estimating expected volatility afforded by FAS 123. In support of this interpretation, we also find that managerial incentives play a key role in this opportunism.