The Subjective and Objective Evaluation of Incentive Stock Options

Incentive options are held bymanagers and employees who invariably hold undiversified portfolios with substantial amounts invested in their own company’s common stock. This lack of diversification makes the subjective value of incentive items such as options less than their market value. This paper derives a model for the marginal value of such options or other incentive items. As such, it can be used to evaluate heterogeneous options which mature on different dates. It can also be used each time a new option is granted. The identical model (with different parameters) can be used to determine three different values for each option, the market value, the subjective value and the objective values. The market value is the value the option would have if it were held by an unconstrained agent. The subjective value — the value of the holder — is less than the market value because the option is held in an undiversified portfolio and because it is exercised suboptimally from the market perspective. The objective value is the cost to the firm of issuing the option and lies between the market and subjective values. This value recognizes the suboptimal exercise but not the undiversified discount. The model is no more difficult to use than is the Black-Scholes model. In fact, under the same conditions, it is simply the Black-Scholes model with modified parameters. The model can also be easily extended to handle vesting, employment termination, indexing, repricing and any number of other features found in incentive options. First Draft: July 2000 This revision: February 2002