ABSTRACT We develop an arbitrage‐free and complete framework to price options on the stocks of firms involved in a merger or acquisition deal allowing for the possibility that the deal might be called off at an intermediate time, creating discontinuous impacts on the stock prices. Our model can be a normative tool for market makers to quote prices for options on stocks involved in such deals and also for traders to control risks associated with such deals using traded options. The results of tests indicate that the model performs significantly better than the Black–Scholes model in explaining observed option prices.

We propose a multiperiod model to value employee options allowing for the possibility that a risk-averse employee strategically exercises her options over time rather than at a single date. Our results describing the representative employee's option exercise behavior are broadly consistent with existing empirical evidence. The value of options to the employee and their effective cost to the firm are significantly different from the predictions of a constrained model that assumes “single date” strategic option exercise. The constrained model substantially underestimates the cost of options to the firm when, ceteris paribus, the employee's relative risk aversion and/or the time to maturity and/or the stock volatility exceed respective thresholds. Hence, the incorporation of “multiple-date” exercise has important economic and accounting consequences.