MODELING AND PRICING EMPLOYEE STOCK OPTIONS

• Main Author: CHENDRA (30112002), ERWINNA
• Format: Dissertations
• Language: Indonesia
• Online Access: https://digilib.itb.ac.id/gdl/view/21988
• Institution: Institut Teknologi Bandung

Employee stock options (ESOs) are call options granted by a company to its employees on the stock of the company. The main idea of granting ESOs are to align the employees incentive with the desire of the company’s shareholders, to motivate employees to work towards improvement of the company’s earning and management, and help companies to retain employees who are highly motivated and potentially. As one form of non-cash compensation, ESOs also are components of efficient cost for small companies to compete with large companies. Companies that grant ESOs to their employees must calculate and report the ESOs fair value (price) in the income statement and the statement of financial position. <br /> <br /> <br /> ESOs have special characteristics that distinguish them from standard options. While standard options usually mature within one year, ESOs have long maturity ranging from 5 to 15 years. Usually, ESOs are not immediately exercisable. The company usually wants to maintain the incentive effect by prohibiting the employees from exercising during a certain period (the vesting period) of the option’s life. In case of the employee leaves the company during the vesting period then ESOs are forfeited (i.e. they become worthless). If the ESOs holder leaves the company after the vesting period, then the options will be exercised if they are in-the-money and forfeited if out-of-the-money. Once awarded with an ESOs, the employee cannot sell or transfer them. The sale restrictions may induce the ESOs holder to exercise them earlier (i.e. ESOs have American option feature). All the characteristics of the ESOs had a significant impact on the ESOs. The ESOs price can be calculated using an option pricing model, such as the Black-Scholes model or lattice model. Some researchers have proved that the ESOs price determined by the Black-Scholes model is likely to exceed the ESOs actual price, because the Black-Scholes model handles an early execution feature by reducing the option’s life. Beside that, the Black-Scholes model does not consider about the vesting period and the dilution effect. Dilution is a decreasing in the company's stock price as a result of the execution ESOs by employees. Therefore, lattice models and Monte Carlo method with modification to meet the characteristics of ESOs can be used. Lattice models and Monte Carlo method have several advantages, they are flexible, easy to implement, and can accommodate functions with a complex payoff. <br /> <br /> <br /> This research develops the ESOs model that consider about the employee’s execution strategy, the limited of execution periods (Bermudan option feature), and the sequential execution to maximize the present value of the lump sum of the ESOs holder future disposable incomes, which is defined as his salary plus ESOs payoff minus the progressive income tax. This research also developed a three dimensional (3D) lattice model to determine the ESOs price with sequential execution that considers about the dilution effect. This 3D lattice models is called the Forest model, which is composed of several lattices and each lattice simulates one possible dilution scenario. Each node of the lattice contains a table for analyzing the optimal exercising strategy at that node. The transition among the nodes in the forest models the sequential executions of an employee and the corresponding dilutions. This Forest model can also be modified to determine the price of various derivatives in addition to ESOs. Furthermore, this research also developed the ESOs model prevailing in Indonesia that contains of the American option feature, the Bermudan option feature, and the Asian option feature with an partial average (average over a part of the option’s life). This Indonesian ESOs price is determined by the lattice model that has been modified to meet the additional characteristics of Indonesian ESOs. Numerical experiments are given to verify the robustness of the lattice and to analyze the sensitivity of the ESOs price with respect to model parameters.