outstandingatafirm,wearelookingatamixofvestedand
nonvestedoptions. Thenonvestedoptions should be worth
lessthanthevestedoptions,buttheprobabilityofvestingwill
dependonhowin-the-moneytheoptionsareandtheperiod
left for an employee to vest. There have been attempts
13 to develop option pricing models that allow for the
possibilitythat employeesmayleave a firmbeforevesting
and forfeit the value of their options. Carpenter (1998)
developedasimpleextensionofthestandardoptionpricing
modeltoallowforearlyexerciseandforfeiture,anduseditto
value executive options.
14 Sincethenewaccountingstandards governingemployee
optionsrequirefirmstoestimateforfeitureratesatthetimeof
thegrant,therewill undoubtedlybe attemptstobuild new
models for vesting and forfeiture.
Illiquidity
Employees whoarecompensatedwithoptions canbecome
wealthy onpaperbut maynot be ableto cash in on their
implicit wealth because the options cannot be traded. In
addition,itisofteninfeasibleorevenillegaltohedgethese
options.Theeffectofthisilliquidityonoptionvaluehasbeen
both widely studied and well debated. In particular, the
illiquidityoftheseoptionsmayinduceemployeestoexercise
options early and give up the time premiums on these options.
Whilesomehavearguedthatearlyexerciseisirrational,there
areclearlygood reasonsforearlyexercise.Huddart (1994)
showsthatearlyexerciseisinfactoptimalforarisk-averse
investor.
15 Lambert,Larcker, and Verrecchia(1991) and Hemmer,
Matsunaga,andShevlin(1994)showthatrestrictionsonshort