Non-Transferable Non-Hedgeable Executive Stock Option Pricing

We introduce a novel method of valuating non-transferable non-hedgeable (NTNH) contingent claims and implement this method in pricing executive stock options. While local co-linearity caused by derivative assets renders common portfolio optimization methods ineffective, we show that NTNH constraints break this co-linearity. We are, thus, able to translate portfolios that include NTNH derivatives into portfolios that consist of primary assets only. We do that by replicating derivatives using primary assets and, then, integrating the NTNH constraints into a single rectangular constraint. Solving the constrained portfolio optimization problems identify stochastic discount factors that price any contingent claim in such portfolios. We use this method to price NTNH European and American executive stock options for block exercise or a continuum of exercise ratios. Identifying executives’ endogenous optimal exercise policies we find, the objective price (cost) of ESOs to firms.

Keywords: Executive Stock Options, Constrained Portfolio Optimization, Stochastic Discount Factor, Non-Hedgeable, Non-Transferable

JEL Classification: G11, G13, C02, C61

Suggested Citation: Suggested Citation

Colwell, David B. and Feldman, David and Hu, Wei, Non-Transferable Non-Hedgeable Executive Stock Option Pricing (September 8, 2013). 26th Australasian Finance and Banking Conference 2013, Available at SSRN: https://ssrn.com/abstract=2325601 or http://dx.doi.org/10.2139/ssrn.2325601