THE VALUE OF BEING LUCKY: OPTION BACKDATING AND NONDIVERSIFIABLE RISK

Vicky Henderson, Jia Sun () and A. Elizabeth Whalley ()
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Vicky Henderson: Department of Statistics, University of Warwick, Coventry CV4 7AL, UK
Jia Sun: China Credit Rating Co. Ltd., 28 Jin Rong Street, Beijing 100032, China
A. Elizabeth Whalley: Warwick Business School, University of Warwick, Coventry CV4 7AL, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2021, vol. 24, issue 04, 1-26

Abstract: The practice of executives influencing their option compensation by setting a grant date retrospectively is known as backdating. Since executive stock options are usually granted at-the-money, selecting an advantageous grant date to coincide with a low stock price will be valuable to an executive. Empirical evidence shows that backdating of executive stock option grants was prevalent, particularly at firms with highly volatile stock prices. Executives who have the opportunity to backdate should take this into account in their valuation. We quantify the value to a risk averse executive of a lucky option grant with strike chosen to coincide with the lowest stock price of the month. We show the ex ante gain to risk averse executives from the ability to backdate increases with both risk aversion and with volatility, and is significant in magnitude. Our model involves valuing the embedded partial American lookback option in a utility indifference setting with key features of risk aversion, inability to diversify and early exercise.

Keywords: Utility indifference pricing; American options; lookback options; option backdating; executive stock options (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1142/S0219024921500230

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