Home' A Plus Magazine : Nov 2012 Contents An option is a derivative
financial instrument that
specifies a contract between
two parties for a future
transaction on an underlying asset at a
pre-determined strike price. The value of an
option is primarily derived from the intrinsic
value difference between the strike price
and the value of the underlying asset, plus a
premium based on the time remaining until
the expiration of the option.
Share options are important to today's
financial market and businesses. Not only
because share options are widely listed in
stock exchanges as investment vehicles,
but also because companies use options for
business purposes such as currency hedging
and employee remuneration.
This article focuses specifically on the
valuation of share options for IFRS 2 Share-
based Payment and covers pricing models,
valuation practices and relevant accounting
Impact of IFRS 2
In 2005, the International Accounting
Standards Board introduced IFRS 2
to address the issue of accounting for
remuneration paid to employees in the form
of equity or derivatives of equity.
Before IFRS 2, employee stock options
affected only a company's profit and loss if
options were exercised, and the impact was
solely based on the options' intrinsic values.
Under IFRS 2, in order to correctly recognize
employee stock options on a company's
financial statement, both a valuation exercise
and accounting exercise are required.
The valuation exercise is required in
respect of the fair value of the employee stock
options at the date they were granted, and an
accounting exercise is required in respect of
the extent to which the grant-date fair value is
charged to the company's profit and loss.
Employee stock option
An employee stock option is a call option on
the common stock of a company, granted
by the company to employees as part of an
employee's remuneration package.
The primary objective is to align
employee interests with the company and
give employees an incentive to behave in ways
that will boost the company's stock price.
Two key advantages of employee stock
option schemes are (1) they provide an
incentive to employees without any cash
flow implications to the company, and (2)
there is no upfront cost of participation and
employees only exercise when there is an
appreciation in the value of the company.
Option pricing model
A number of well established valuation
models are available to estimate the fair
value of share options. While no particular
option pricing model is regarded as
theoretically superior to others, the Black-
Scholes-Merton model and the binomial tree
model are the two most widely used.
The Black-Scholes-Merton model is an
example of a closed-form model, which is
characterized by the use of an equation to
produce an estimated fair value.
In 1973, Fischer Black and Myron Scholes
achieved a significant breakthrough when
they determined the premium for a stock
option in terms of parameters that are
directly observable or may be estimated
using historical data. The ideas were
groundbreaking and eventually led to
Scholes and Robert Merton winning the 1997
Nobel economics prize.
While the theory behind the Black-
Scholes-Merton formula is complex,
applying the formula is relatively
straightforward. Typically, the Black-Scholes-
Merton model is better suited to value short-
term, exchange-traded share options than
long-term, tailor-made share options.
Binomial tree model
In contrast to the Black-Scholes-Merton closed-
form model, the binomial tree model is a
lattice, producing an estimated fair value based
on the assumed changes in prices of a financial
instrument over successive periods of time.
First developed in 1979, the binomial
tree model uses an iterative procedure,
allowing for the specification of nodes, or
points in time, during the time span between
the valuation date and the instrument's
The model reduces possibilities of price
changes, removes the possibility for arbitrage,
assumes a perfectly efficient market and
shortens the duration of the instrument.
Under these assumptions, it is able to provide
a mathematical valuation of the instrument at
each point in time specified.
The key difference between a lattice
model and a closed-form model is flexibility.
A lattice model can explicitly use dynamic
assumptions regarding the term structure of
volatility, dividend yields and interest rates.
Furthermore, a lattice model can
incorporate market conditions that may be
part of an options' design. Thus valuation
specialists believe that the binomial tree
model provides a more accurate estimate of
a share option's fair value.
In the process of estimating the fair value of
a share option, despite the valuation model
adopted, a minimum of six inputs (expected
life, current share value, exercise price,
Unveiling valuation of options
for IFRS 2 Share-based Payment
Alex Leung and Ross Wang examine models, practices and accounting
requirements in the use of share options for remuneration
46 November 2012
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