Is Black-Scholes Always the Right Option?

Is Black-Scholes Always the Right Option?Zoom inDownload PDF

After years of falling out of favor — due to both the financial crisis and proxy advisers considering them non-performance based — companies are once again considering the use of stock options to motivate and reward their executives and employees. Stock options are one of the best long-term incentives to encourage growth and create a longer-term orientation to executive compensation programs. Stock options also fill a hole in contemporary long-term incentive designs and can be effective in creating additional alignment with shareholders. However, stock option values can be volatile, and companies need to be thoughtful about how awards are calibrated.

In most contexts, the Black-Scholes model, which is the most common model used to determine the fair price or theoretical value of a stock option for accounting purposes, appears to work well for determining how many stock options to award to individual recipients as part of an incentive compensation package. Using the Black-Scholes value also makes sense on the surface: The value of the options is aligned with the accounting cost and the option awards can be calibrated on an apples-to-apples basis across companies. Indeed, the majority of compensation surveys rely on Black-Scholes to value options and nearly all publicly traded companies use the model to report the value of equity that they are granting to their senior executives. What’s not to like?

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