The NASPP Blog

Volatility is one of the inputs used to calculate a Black-Scholes model valuation of stock options. As volatility increases, so does the maximum gain that an employee could realize through a future exercise of their option. This, in turn, increases the value of that option, which may be a difficult concept to reconcile when the volatility is increased because of a down market!

With the recent turmoil in the stock markets, companies may find that the volatility they are using to value their stock options is jumping up as their stock price drops. Whether companies are using implied volatility or their own historical volatility, the recent changes in stock price could have impacted those numbers dramatically. There was a thread on this in our NASPP Discussion Forum recently on how to handle these changes, and I’m sure the question on many peoples’ minds right now is “should my company be doing something to deal with this increase in volatility?”

Companies may have created their method of calculating the volatility assumption without anticipating such a sharp downturn in the market. Now, they are looking at their method to see if it is still the best approach. The real intent of calculating volatility is to provide the best estimation of what future volatility will be. Ideally, the period of time the company is using to analyze historical or implied volatility will be long enough to provide an appropriate amount of stability which will accommodate short-term fluctuations. The shorter the period of time being analyzed, the more impact short-term fluctuations have, which may not be a reasonable reflection of what the company’s stock price volatility will look like over the life of the option. On the other hand, won’t options granted during this economic downturn have a higher chance of realizing gain through a dramatic increase in stock price over the life of the grant?

If this is the beginning of the fiscal year for your company, then it is a good time to take a look at how you are coming up with your valuation assumption. This is your opportunity to review your process for estimating volatility to see if it really is the most appropriate. Keep in mind, however, that FAS 123(R) clearly states that the method for determining the estimates should not only be “reasonable and supportable” (Paragraph 16), but also be “determined in a consistent manner from period to period” (Paragraph 23). So, if you are considering a change, such as an increase in length of time included in the calculation or a change to the way you weigh different periods, you will need to make sure that it is a change your company can not only justify to your auditors now, but also sustain as a valid method going forward.

For more information on your valuation assumptions, check out this article from Towers Perrin, Granting Stock Options in Turbulent Times: Take Care When Choosing Valuation Assumptions, in our Stock Plan Expensing portal. Also, get an idea of how your method for determining volatility measures up against other companies by taking our Compliance-O-Meter quiz on Volatility. We’ve got one for private companies and one for public companies.

-Rachel