Black-Scholes models lose favour for employee stock options

Companies around the world are likely to come under increasing pressure to change their valuation methodologies for employee stock option schemes from traditional Black-Scholes models to binomial approaches, according to the research department of Bear Stearns in New York.

In a research report released today, the US bank said the Financial Accounting Standards Board (FASB) had indicated that it planned to draft new mark-to-market rules on employee stock options to “encourage companies to use a binomial model if the information is available to do the calculation”. But FASB has hinted that it would not specifically mandate any particular approach.

However, Bear Steans said all but eight companies in the S&P 500 index may come under pressure to switch to binomial pricing. Only Ameren, AIG, Boeing, Cincinnati Financial, Dow Chemical, Goldman Sachs, MeadWestvaco and Washington Mutual have used such an approach to date.

It is unclear what has underpinned FASB’s thinking. But both binomial and Black-Scholes models are limited in requiring implied volatility inputs that can prove highly subjective.

But the US accounting standards-setter has co-ordinated its activities with the International Accounting Standards Board (IASB) in this area. So companies adopting IASB reporting standards are also likely to come under increasing pressure to use binomial models.