In short
Option-pricing models estimate the fair value of stock options. The Black-Scholes-Merton model is a closed-form formula; lattice (binomial) models are more flexible, handling early exercise and changing assumptions.
Key takeaways
- Inputs include the share price, exercise price, expected term, expected volatility, expected dividends and the risk-free interest rate.
- Higher volatility and a longer term increase an option's value; higher expected dividends decrease it.
- Private companies may use an industry index's volatility if their own can't be estimated.
Where it's tested
BAR: Stock Compensation — study notes, a five-minute revision sheet and practice questions.
Practise: 3 questions
Question 1 of 3 · 0 answered
A company grants options that vest only if the share price reaches $50 within three years. The employees complete the service period, but the share price never reaches $50. How is compensation expense treated?