Accounting for Employee Stock Options: a small refinement to the lattice approach

Hull and White (2004) have developed a lattice pricing model that makes explicit reference to parameters that are not available in Black Scholes (1973) yet are important for the pricing of these Employee Stock Options (ESOs).... [ view full abstract ]

Hull and White (2004) have developed a lattice pricing model that makes explicit reference to parameters that are not available in Black Scholes (1973) yet are important for the pricing of these Employee Stock Options (ESOs). Cvitanic, Wiener and Zapatero (2008) point out that a key weakness of the lattice approach, when applied to valuing ESOs, is the sluggish convergence not generally experienced in trees configured to estimate plain vanilla European options. Cvitanic, Wiener and Zapatero (2008) propose a very useful closed form solution which may or may not be endorsed by a whole host of regulatory and professional bodies. In this paper, we propose a small refinement to Hull and White (2004), based on insights developed by Boyle and Lau (1994) which ensures faster convergence in lattice estimation. Our model provides estimates consistent with Cvitanic, Wiener and Zapatero (2008). The proposed model should also neatly fit into the rubric currently prescribed by the American Financial Accounting Standards Board (FASB) and endorsed by staff at the Securities Exchange Commission (SEC).