Using Sectoral Indexes to Discount the Exercise Price of Employee Stock Options

Abstract

Abstract Employee stock options (ESOs) are an instrument in compensating top management of corporations. In the literature, they are described as a variable component of remuneration of a long-term character (Borkowska, 2012). There are six characteristic elements of the ESO: a grant date, the ESO plan duration, employees entitled to receive options, vesting criteria, a vesting period, and an exercise price. The article refers to the exercise price. The remuneration of employees is determined by the option’s intrinsic value, i.e. the difference between the current stock price and the exercise price. This difference affects the costs incurred by a company in relation with their incentive stock option plan. In this connection, the exercise price of stock options needs to be analysed. The literature shows that usually the strike price is equal to the stock market’s value at the time the option is granted. The options issued with an exercise price equal to the market value of the company’s stock on the date of the grant usually lead to at-the-money options. Walker (2009) mentions that almost all options issued by US firms have been such type of options. Hence, the options with exercise prices less than the prices of the underlying assets have been rarely observed. One of the solutions can be discounting the exercise price by using sectoral indexes, which are sensitive to changes on a particular market. The purpose of this paper is to address several aspects of specifying the exercise price in ESOs. The research shows how sector indexes can be used to discount it. Using sectoral indexes in determining the exercise price can partly limit the unreasonably high profits from the ESO. The literature does not provide ready-made formulas of exercise prices based on specific variables. The aim of the research is to present and apply the formula of the exercise prices in which sectoral indices are used to discount. The data are from the Warsaw Stock Exchange (WSE) and include those companies that revealed the information concerning their incentive programs in 1999–2013. The relevant data come from annual reports, current reports, supervisory boards’ resolutions, and press announcements.