Estimation of Employee Stock Option Exercise Rates and Firm Cost

This paper is the first to perform a comprehensive estimation ofemployee stock option exercise behavior and option cost tofirms. Wedevelop a GMM-based methodology, robust to heteroskedasticity andcorrelation across exercises, for estimating the rate of voluntaryoption exercise as a function of the stock price path and of variousfirm and option holder characteristics. We use it to estimate anexercise function for a sample of 1.4 million employee-option grants to562,311 employees at 87 publicly-tradedfirms between 1980-2007. We alsoestimate the rate of employment termination, which determinesforfeitures, cancellations, and forced exercises. We use the estimatedexercise and termination functions in a simulation based valuation modelto analyze the effect of different firm and option holdercharacteristics on option value, and show that the true value of theseoptions can differ substantially from values calculated using the usualmodified Black-Scholes approximation.