Analytical Pricing of Executive Stock Option Structures with Incentivisation via Performance Based Vesting and ...

Executive Stock Options (ESOs) are commonly used methods for incentivising employee emuneration and represent major items of corporate liability when issued to senior executives. The IFRS9 international financial reporting standards and the AASB9 Australian equivalents require their objective actuarial evaluation at fair-value valuation via the Fair Value through Profit and Loss (FVTPL) category. The latest standards became mandatory on 1 Jan 2018. Typically ESOs have vesting periods where exercise is not allowed followed by exercise windows where the employee may voluntarily exercise their option. Aligning executive performance with reward, shareholder pressure and corporate governance issues however all naturally motivate remuneration structures incorporating performance conditions for the stock options granted by firms. Common market-based performance criteria typically require that total shareholder return of the company's stock exceed that of the company's peers, such as a competitor company, a group of competitor companies or alternatively a broad market index. To this end we introduce a general performance-based vesting structure which incorporates performance conditions on the issuer’s shareholder return, outperformance of the return of a market competitor and the outperformance of a broad market index. We extend previous analysis and consider the technical issues arising from the incorporation of continuously monitored performance-based vesting conditions to incentivise executives. In this vein we propose alternate incentivisation by requiring the issuer’s shareholder return to continuously outperform that of a major competitor or a broad market index during the vesting period before option exercise is allowed. This contrasts with performance assessment restricted to the vesting date. We present non-trivial generalisations of our pricing methods for the efficient and completely analytical treatment of our proposed remuneration structures. We incorporate post-vesting voluntary early exercise using the Hull and White (2004) characterisation. Notwithstanding the path dependence, we express all our analytical results as portfolios of several classes of European option instruments explicitly derived in closed form. We present analytical results and time permitting, numerical implementations and the effect of survival adjustment on the fair valuation. All valuations are consistent with IFRS9 requirements for practitioner implementation.