The use of options as compensation for non-executive employees is a puzzle. Standard, rational, valuation models show that the cost of issuing options is larger than the value placed on the options by employees. Existing explanations for this puzzle are based upon static models that ignore the considerable dynamic aspects of employee stock option pricing and exercise behavior. We develop dynamic, multiperiod models of employee preferences considering risk aversion, loss aversion, overconfidence and probability weighting to test possible explanations of the use of employee stock options. We find that a cumulative prospect theory model generates scenarios where employees would prefer options to either cash or equity payments, and also optimally exercise their options early. This is the only model where options are preferred and also optimally exercised early.

Guided by academic literature, industry practice and policy recommendations, we analyze a wide range of option and restricted stock plans with exercise and vesting conditions that may be contingent on stock price performance. To assess the effectiveness of these plans at attracting and providing incentives to executives, we create compensation plans with fixed firm cost and executive valuation and calculate their expected total lifetime incentives. We show that performance vesting targets provide the least cost effective incentives, performance exercise targets provide the largest risk incentives, option plans are generally superior to restricted stock plans, and calendar vesting is only efficient up to a maximum of three years. Performance exercise targets can increase the expected total lifetime incentives provided by compensation plans, but in general, standard options with short vesting periods provide the most cost effective pay-for-performance incentives.

The exposition of the quadrature (QUAD) method (Andricopoulos, Widdicks, Duck, and Newton, 2003. Universal option valuation using quadrature methods. Journal of Financial Economics 67, 447–471 (see also Corrigendum, Journal of Financial Economics 73, 603 (2004)) is significantly extended to cover notably more complex and difficult problems in option valuations involving one or more underlyings. Trials comparing several techniques in the literature, adapted from standard lattice, grid and Monte Carlo methods to tackle particular types of problem, show that QUAD offers far greater flexibility, superior convergence, and hence, increased accuracy and considerably reduced computational times. The speed advantage of QUAD means that, even under the curse of dimensionality, it is not necessary to resort to Monte Carlo methods (certainly for options involving up to five underlying assets). Given the universality and flexibility of the method, it should be the method of choice for pricing options involving multiple underlying assets, in the presence of many features, such as early exercise or path dependency.

This paper proposes and develops a novel, simple, widely applicable numerical approach for option pricing based on quadrature methods. Though in some ways similar to lattice or finite-difference schemes, it possesses exceptional accuracy and speed. Discretely monitored options are valued with only one timestep between observations, and nodes can be perfectly placed in relation to discontinuities. Convergence is improved greatly; in the extrapolated scheme, a doubling of points can reduce error by a factor of 256. Complex problems (e.g., fixed-strike lookback discrete barrier options) can be evaluated accurately and orders of magnitude faster than by existing methods.