Nonlinearity, correlation and the valuation of employee stock options
Abstract
We propose a discrete time algorithm for the valuation of employee stock
options based on exponential indifference prices and taking into account both
the possibility of partial exercise of a fraction of the options and the use of
a correlated traded asset to hedge part of their risk. We determine the optimal
exercise policy under this conditions and present numerical results showing how
both effects can significantly change the value of the option for an employee,
as well as its cost for the issuing firm.