The NASPP Blog

March 24, 2009

Bigger Than Underwater Stock Options – Part 2

Last week I blogged about the ways in which the current market decline is impacting stock plans beyond just making a lot of options not worth anything.  This week I take a look at some of the long-term impacts the market volatility could have in terms of option valuation.

Stock Price Volatility

One concern that I’ve heard discussed in a number of different venues is that all this market fluctuation is wreaking havoc on expected volatilities for stock plans.  Whether your stock is going up or down overall (only .5% of respondents to the NASPP’s quick survey on market volatility and stock plans indicated that their stock had remained flat over the past year), the fact is, it’s probably moving around a lot these days.  And that is likely to cause your estimate of future volatility for option valuation purposes to increase. 

Expected volatility (along with expected life, which we’ll get to next) is one of the most influential factors on option fair value.  The higher your expected life, the higher your option fair values will be.  That might not seem like a big deal now, while your stock price is depressed (and, thus, so are your option fair values) but it could be a very big deal once your stock price starts to recover. If you rely on historical volatility to estimate future volatility, you are likely to be basing your volatility estimate on a historical period that includes the current market for many years to come.  Remember, you generally calculate historical volatility over a period that is commensurate with the expected life of the options being valued, so you could end up including the current volatile market in your estimates for the next four years or longer. 

Expected Life

At the same time that your volatility is going up, if your stock options are underwater, your expected life is probably getting longer.  Underwater options cause employees to wait longer to exercise.  This might be mitigated to some extent by terminations, but unless you are laying off employees, with the job market the way it is these days, most employees probably aren’t going anywhere. 

A longer expected life has two significiant implications: 

  1. In and of itself, a longer expected life means a higher option fair value.
  2. If you use historical volatility to estimate expected volatility, it lengthens the historical period you are using for that analysis. This cause the current period of market instability to remain a part of your expected life calculations for more years into the future. 

What To Do

The articles “Granting Stock Options in Turbulent Times: Take Care When Choosing Valuation Assumptions” by Towers Perrin and “Valuing Stock Options: Is It Time to Reconsider Binomial Lattice Models?” by Watson Wyatt discuss these concerns and ways to mitigate them:

  • Once your stock price stabilizes, consider incorporating implied volatility into your expected volatility analysis
  • Consider expanding the period used to compute historical volatility
  • Consider switching to a binomial or other lattice model

If you haven’t yet started considering the impact the current market environment is having on your option valuations, now is the time to start preparing for this.

Don’t Forget to Resubscribe to the NASPP Blog
If you haven’t already, don’t forget to resubscribe to the NASPP blog so that you will continue to receive email notices of new entries once we discontinue the old notification service. 

M&A Course Begins Today
The NASPP’s newest online educational program, Tackling Equity Compensation Issues Related to Mergers & Acquisitions, begins today, March 24. This course will offer a tactical approach to address the real-world, practical challenges that arise in mergers and acquisitions. Register now to make sure you don’t miss the first webcast (although if you do miss it, you can always catch the recorded archive).

Reason #18 to Renew Your NASPP Membership:  Customized Global Stock Plans Compliance Evaluation
NASPP members can now receive a customized analysis of their global stock plan compliance, courtesy of GlobalSharePlans.  Simply go to the NASPP’s Global Stock Plans Portal and click the link in the left column for the Stock Plan Compliance Evaluation. You can indicate the countries you have stock plan participants in, the number of participants in each country, and whether or not you’ve filed an EU prospectus for the country. The tool will then indicate whether or not you need to seek legal advice for your stock plans in each country. It’s cool–check it out today!


NASPP “To Do” List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blogs. 

– Barbara