Employees Stock Options - Paper Example on Finance

Paper Type:  Article review
Pages:  5
Wordcount:  1123 Words
Date:  2021-06-01

Traditional models that are used to value options and other illiquid assets have always stated the value these assets at a discount to the Black-Scholes model. As a result, most risk-averse investors always look for higher returns to invest in the illiquid assets. However, the costs associated with an asset being illiquid can be offset by market sentiments caused by either positive information about the firm or bright future market expectations (Roggi and Altman, 2013).

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One illiquid asset where the costs of illiquidity can be offset by market sentiments is the Employees Stock Options (ESOs). The value of the ESOs as perceived by the employees may be considerably different from the market value of the asset as shown by the Black-Scholes model. Roggi and Altman (2013) note that various studies put across in academic research show that the values of the ESO should be taken at a discount to the Black-Scholes market value. There has not been any clear empirical evidence to support this position mainly due to lack of appropriate data to use and no explicit closed form model to apply. This gap gives rise to the question of why do employees desire to have ESOs as part of their compensation when their value is usually at a discount to the Black-Scholes market value?

Possible explanations put across for this behavior by the employee investor has been either the employees have some private positive information, or they are simply overconfident about the firms future performance. It is this inability of the existing studies to explain the behavior of the employee investors that prompted this study of the pricing of risk and sentiment with a focus on executive stock options by Chang, Chen, and Fuh (2013).

Analysis

To analyze the impact of opinions on the pricing of illiquid assets, the study focused on compensation data and executive ESOs from 1992 to 2004 for firms using the S&P 1500 index. The study concentrated on the ESOs issued to executives and not to the rank and file employees. The bias on executive ESOs was in large part because the managers are deemed to have more private information about the firm, hold a large portion of the firms ESOs and their ESOs were continually being reviewed by regulatory authorities. From this data, the returns on ESOs to each executive was computed. The executive ESOs data was split into comparable groups based on their titles, ranks, and industry. This classification was necessary to get the inherent value that each executive placed on the ESO relative to their job description and industry (Chang et al., 2013).

With this data, the study reviewed how this intuitive value reacts to instantaneous expected rates of returns for the markets, stock, and risk-free assets. The response of the intuitive value was also analyzed relative to the general systematic market risk, firm-specific idiosyncratic risk, and executive investor sentiments. The model used provided a closed form solution to the Employees Stock Options where the executives were supposed to choose between the underlying stock, market portfolio and a risk-free asset. Using this model and applying partial derivatives, it was possible to get the Black-Scholes market value of ESOs as a result of them being illiquid and the sentimental ESO value as perceived by the executive employee investors (Chang et al., 2013).

The results of the study showed that the intuitive value of the ESO as perceived by the executives was higher than the market value as per the Black-Scholes model in all but one of the industries surveyed. The presence of the investor sentiment variable in the model largely explained the difference between the ESO value as judged by the executives and the Black-Scholes value. Most of the investor sentiments as related to a positive feeling about the respective firms future and not private insider information. The results also showed that while there was a positive relationship between investors subjective value and sentiments levels, there was a negative relationship between investors subjective value and the proportion of ESO held in particular firms (Chang et al., 2013).

Further, the subjective value had either positive or negative relationship with market volatility. The positive correlation came as a result of the general assumption that the higher the risk and volatility levels the higher the value of Employee Share Option. The negative relationship between the employee investors intuitive value and volatility is attributable to the notion that simply because the ESO has low risk does not mean that it is less desirable. There are those executives who would prefer less volatile ESOs and their demand pushes up the value of the ESOs. This result is different from the traditional Black-Scholes model which only finds a positive relationship between subjective value and market volatility. Finally, the study found a negative correlation between the subjective value of ESOs and idiosyncratic risks. This was because when the firm faces internal risks, then the values of its ESOs were equally lower (Chang et al., 2013).

Recommendations

This paper investigated the impact of illiquidity of ESOs and the effect of investor sentiments and private insider information on the pricing of the Employees Stock Options. Based on the findings, it follows that sentiments are a key variable in estimating the value of illiquid assets and more so options. Firms that have outstanding financial performance are encouraged to issue more options as compensation to their employees. Those firms planning to issue as well as those that have issued the options as compensation to its employees should maintain positive sentiments internally. While ESOs may be used as incentives to employees to work hard and take some specific risks, executives holding ESOs are discouraged to from too much idiosyncratic risk as this might lower the value of the ESO (Chevalier-Roignant, Trigeorgis, & Dixit, 2011).

Conclusion

Evidence from the sampled firms as per the S&P 1500 index showed that the intuitive value of ESOs as perceived by the employee investors differ significantly from the expected value as per the Black-Scholes model. The closed form model applied here offers an alternative approach to valuing illiquid assets particularly when market sentiments need to be considered. While it does not fully incorporate all variables required in explaining how attitudes and risk correlate, it opens up areas of further research in the pricing of risk and sentiments (Chang et al., 2013).

References

Chang, C., Chen, L., & Fuh, C. (2013). The Pricing of Risk and Sentiment: A Study of Executive Stock Options. Financial Management, 42(1), 79-99. Retrieved from http://www.jstor.org/stable/43280128Chevalier-Roignant,

B., Trigeorgis, L., & Dixit, A. (2011). Uncertainty, Flexibility, and Real Options. In Competitive Strategy: Options and Games (pp. 153-192). MIT Press. Retrieved from http://www.jstor.org/stable/j.ctt5hhbmq.11Roggi,

O., & Altman, E. (2013). Managing and measuring risk: Emerging global standards and regulation after the financial crisis. Hackensack, NJ: World Scientific.

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Employees Stock Options - Paper Example on Finance . (2021, Jun 01). Retrieved from https://midtermguru.com/essays/employees-stock-options-paper-example-on-finance

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