Does Stock Return Predictability Affect ESO Fair Value?

Julio Carmona, Angel León () and Antoni Vaello-Sebastià
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Angel León: Universidad de Alicante, Departamento de Métodos Cuantitativos y Teoría Económica, Postal: Departament of Quantitative Methods and Economic Theory, Universidad de Alicante, Campus de San Vicente del Raspeig, Ap-99, 03080, Alicante, Spain

No 11-2, QM&ET Working Papers from University of Alicante, D. Quantitative Methods and Economic Theory

Abstract: Executive Stock Options (ESOs) are modified American options that cannot be valued using standard methods. With a few exceptions, the literature has discussed the ESO fair value by assuming unpredictable stock returns which are not supported by the available empirical evidence. In this paper we obtain the fair value of American ESOs when stock returns are predictable and, specifically, driven by the trending Ornstein-Uhlenbeck process of Lo and Wang (1995). We solve the executive’s portfolio allocation problem for a simple buy-and-hold strategy when his wealth can be distributed between a risk-free asset and a market portfolio. This problem is jointly solved with the executive’s optimal exercise policy. We find that executives tend to wait longer the higher the predictability, independently of the composition of executive’s asset menu. We have also analyzed the implications under the FAS123R proposals for the ESO fair value and found that, even for low autocorrelations, there is a meaningful mispricing when unpredictable returns are erroneously assumed.

Keywords: Executive Stock Options; Risk Aversion; Undiversification; Predictability; FAS123R (search for similar items in EconPapers)
JEL-codes: G11 G13 G17 G35 M52 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2011-11-03, Revised 2012-01-16
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Journal Article: Does stock return predictability affect ESO fair value? (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:ris:qmetal:2011_002

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