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Valuing Employee Stock Options Part 3

Chapter 3: Impact on Valuation. In options analysis, there are three mainstream methodologies and approaches used to calculate an option’s value. | 3 Impact on Valuation A BRIEF DESCRIPTION OF THE DIFFERENT METHODOLOGIES In options analysis there are three mainstream methodologies and approaches used to calculate an option s value 1. Closed-form models like the Black-Scholes model also known as the Black-Scholes-Merton model henceforth known as BSM and its modifications such as the Generalized Black-Scholes model GBM 2. Monte Carlo path-dependent simulation methods 3. Lattices binomial trinomial quadranomial and multinomial lattices However the mainstream methods that are most widely used are the closedform models BSM and GSM and the binomial lattices. No matter which types of stock options problems you are trying to solve if the binomial lattice approach is used the solution can be obtained in one of two ways. The first is the use of risk-neutral probabilities and the second is the use of marketreplicating portfolios. Throughout the analysis the risk-neutral binomial lattice approach is used and can be simply termed binomial lattices. 1 The use of a replicating portfolio is more difficult to understand and apply but the results obtained from replicating portfolios are identical to those obtained through risk-neutral probabilities. So it does not matter which method is used nevertheless application and expositional ease should be emphasized and thus the risk-neutral probability method is preferred. SELECTION AND JUSTIFICATION OF THE PREFERRED METHOD Based on the analysis in Chapter 5 and my prior published study that was presented to the FASB s Board of Directors in 2003 it is concluded 19 20 IMPACTS OF THE NEW FAS 123 METHODOLOGY that the BSM albeit theoretically correct and elegant is insufficient and inappropriately applied when it comes to quantifying the fair-market value of ESOs.2 This is because the BSM is applicable only to European options without dividends where the holder of the option can exercise the option only on its maturity date and the underlying stock does not pay any dividends.3 However .