Employee Stock Option Exercise Behavior and Valuation

Observed employee stock option (ESO) exercise behavior differs from that of similar tradable stock options (TSO). ESOs are exercised earlier than traditional option valuation models predict. A general literature conclusion is ESO behavioral differences are due to ESO trading restrictions compromising ESO holder diversification and causing risk-averse ESO holders to value ESOs below similar TSO market values. I present a new theory of ESO exercise behavior and valuation that is not dependent on compromised diversification arguments.;I develop the Trading Hypothesis. It contends, even in the presence of fully diversified ESO holders, ESO exercise will occur earlier than traditional option valuation models predict. For the same reasons TSO holders sometimes exit their positions via trading (sale), ESO holders will sometimes wish to exit their positions. Because exercise is the only exit strategy available to ESO holders, ESO exercises beyond those predicted by traditional option valuation models are analogous to TSO trading. I explore the implications of the Trading Hypothesis for early ESO exercise behavior, ESO valuation and firm ESO cost. A key implication is just as TSO trading does not affect TSO option valuation, analogous ESO "trading" exercise does not deleteriously affect ESO values.;I develop a Trading Hypothesis model and use simulated output to demonstrate Trading Hypothesis behavior is consistent with ESO literature empirical results. I perform empirical tests of the Trading Hypothesis by comparing ESO exercise behavior to TSO trading. A regression/correlation study finds 1) ESO exercise is related to TSO trading and 2) explanatory variables used in the literature to support diversification explanations of ESO exercise behavior have similar relationships to TSO trading. Because TSO markets are not subject to diversification restrictions, the diversification explanation of ESO exercise behavior is challenged. I also conduct an empirical test of ESO exercise that distinguishes diversification motivated exercise from trading motivated exercise. I find evidence in support of the Trading Hypothesis.