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

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 firm9s 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.