New Zealand Institute for the study of competition and regulation inc.

Abstract

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market-based option pricing models assume that options are continuously tradable and thus that option holders are indifferent to the specific risk of the firm. ESOs, by contrast, cannot be traded and so their cost depends on the risk aversion and under-diversification characteristics of the recipient. Using hypothetical ESOs, we show that ESO cost is extremely sensitive to employee characteristics, thereby casting doubt on the usefulness of any market-based model. Incorporating early exercise in the latter does nothing to resolve this problem, because the optimal exercise policy is itself dependent on holder characteristics which are typically unobservable. Vesting restrictions help reduce the magnitude of error.