Estimation of Employee Stock Option Exercise Rates and Firm Cost

Abstract

This paper is the first to perform a comprehensive estimation of employee stock option exercise behavior and option cost tofirms. We develop a GMM-based methodology, robust to heteroskedasticity and correlation across exercises, for estimating the rate of voluntary option exercise as a function of the stock price path and of various firm and option holder characteristics. We use it to estimate an exercise function for a sample of 1.4 million employee-option grants to 562,311 employees at 87 publicly-tradedfirms between 1980-2007. We also estimate the rate of employment termination, which determines forfeitures, cancellations, and forced exercises. We use the estimated exercise and termination functions in a simulation based valuation model to analyze the effect of different firm and option holder characteristics on option value, and show that the true value of these options can differ substantially from values calculated using the usual modified Black-Scholes approximation.