ESO valuation with job termination risk and jumps in stock price

DOI10.1137/130937949zbMATH Open1333.60082arXiv1504.08073OpenAlexW3123783535MaRDI QIDQ2941470FDOQ2941470

Authors: Tim Leung, Haohua Wan 

Publication date: 28 August 2015

Published in: SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Abstract: Employee stock options (ESOs) are American-style call options that can be terminated early due to employment shock. This paper studies an ESO valuation framework that accounts for job termination risk and jumps in the company stock price. Under general L'evy stock price dynamics, we show that a higher job termination risk induces the ESO holder to voluntarily accelerate exercise, which in turn reduces the cost to the company. The holder's optimal exercise boundary and ESO cost are determined by solving an inhomogeneous partial integro-differential variational inequality (PIDVI). We apply Fourier transform to simplify the variational inequality and develop accurate numerical methods. Furthermore, when the stock price follows a geometric Brownian motion, we provide closed-form formulas for both the vested and unvested perpetual ESOs. Our model is also applied to evaluate the probabilities of understating ESO expenses and contract termination.

Full work available at URL: https://arxiv.org/abs/1504.08073

Recommendations

• ACCOUNTING FOR RISK AVERSION, VESTING, JOB TERMINATION RISK AND MULTIPLE EXERCISES IN VALUATION OF EMPLOYEE STOCK OPTIONS
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• Pricing executive stock options under employment shocks
• A reduced form model for ESO valuation. Modelling the effects of employee departure and takeovers on the value of employee share options
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zbMATH Keywords

Fourier transform[https://portal.mardi4nfdi.de/w/index.php?title=+Special%3ASearch&search=L%EF%BF%BD%EF%BF%BDvy+processes&go=Go L��vy processes]employee stock optionsvariational inequalityjob termination

Mathematics Subject Classification ID

Processes with independent increments; Lévy processes (60G51) Derivative securities (option pricing, hedging, etc.) (91G20) Variational inequalities (49J40) Stopping times; optimal stopping problems; gambling theory (60G40) Optimal stopping in statistics (62L15) Financial applications of other theories (91G80)

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Cited In (8)

• Constrained viscosity solution to the HJB equation arising in perpetual American employee stock options pricing
• A top-down approach for the multiple exercises and valuation of employee stock options
• A humanized model of employee stock options in Black-Scholes framework
• Valuation of employee stock options using the exercise multiple approach and life tables
• Employee stock options. Exercise timing, hedging, and valuation
• A reduced form model for ESO valuation. Modelling the effects of employee departure and takeovers on the value of employee share options
• Employee stock options: an up-and-out protected barrier call
• The value of being lucky: option backdating and nondiversifiable risk

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