Pricing Employee Stock Options (ESOs) with Random Lattice

Abstract

Employee Stock Options (ESOs) are stock options granted by companies to their employees. Unlike standard options that can be traded by typical institutional or individual investors, employees cannot sell or transfer their ESOs to other investors. The sale restrictions may induce the ESO’s holder to exercise them earlier. In much cited paper, Hull and White propose a binomial lattice in valuing ESOs which assumes that employees will exercise voluntarily their ESOs if the stock price reaches a horizontal psychological barrier. Due to nonlinearity errors, the numerical pricing results oscillate significantly so they may lead to large pricing errors. In this paper, we use the random lattice method to price the Hull-White ESOs model. This method can reduce the nonlinearity error by aligning a layer of nodes of the random lattice with a psychological barrier.