Does stock return predictability affect ESO fair value?

Executive Stock Options (ESOs) are modified American options that cannot be valued using standard methods. With a few exceptions, the literature has discussed the ESO fair value by assuming unpredictable stock returns which are not supported by the available empirical evidence. In this paper we obtain the fair value of American ESOs when stock returns are predictable and, specifically, driven by the trending Ornstein–Uhlenbeck process of Lo and Wang (1995). We solve the executive’s portfolio allocation problem for a simple buy-and-hold strategy when his wealth can be distributed between a risk-free asset and a market portfolio. This problem is jointly solved with the executive’s optimal exercise policy. We find that executives tend to wait longer the higher the predictability, independently of the composition of executive’s asset menu. We have also analyzed the implications under the FAS123R proposals for the ESO fair value and found that, even for low autocorrelations, there is a meaningful mispricing when unpredictable returns are erroneously assumed.

► We analyze return predictability effects on the fair value of executive stock options.
► We use a Trending Ornstein-Uhlenbeck process instead of the typical GBM.
► The expected life of the ESOs increases with the predictability of stock returns.
► The one state-variable model (S1) becomes similar to S2 model under predictability.
► Even for low predictability, a meaningful mispricing arises when a GBM is assumed by mistake.