Employee Reload Options: Pricing, Hedging, and Optimal Exercise

Abstract

Reload options, call options granting new options on exercise, are popularly used in compensation. Although the compound option feature may seem complicated, there is a distribution-free dominant policy of exercising reload options whenever they are in the money. The optimal policy implies general formulas for numerical valuation. Simpler formulas for valuation and hedging follow from Black–Scholes assumptions with or without continuous dividends. Time vesting affects the optimal policy, but numerical results indicate that it is nearly optimal to exercise in the money whenever feasible. The results suggest that reload options produce similar incentives as employee stock options and share grants. The valuation of options in compensation schemes is important for several reasons. Valuations are needed for preparing accounting statements and tax returns, and more generally for understanding what value has been promised to the employees and what residual value remains with the shareholders. Furthermore, understanding the hedge ratios and the overall shape of the valuation function clarifies the employee’s risk exposure and incentives. This article studies the optimal exercise and valuation of a relatively new but increasingly commonplace type of employee stock option, the reload option. These options have attracted a fair amount of controversy; we believe that in large part this controversy is due to a seemingly complex structure. In the Statement of Financial Accounting Standards (SFAS) 123 [Financial Accounting Standards Board (1995)], paragraph 186 concludes, “The Board continues to believe that, ideally, the value of a reload option should be estimated on the grant date, taking into account all of its features. However, at this time, it is not feasible to do so.” On close examination, however, these options are in fact comparatively simple to analyze and understand. Moreover, under Black and Scholes (1973) assumptions on the stock price, we are able to provide explicit valuation and hedging formulas. We hope our analysis helps to demystify reload options and permit a more focused debate.