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How do these factors affect employees’ valuation of the option grant?
The risk-averse nature of most employees means that they forfeit the remaining time value of the option (by exercising early) to reduce risk. Hence the BS model over-estimates the value (i.e. benefits) of the ESOs to the employees. Another limitation of using the BS model is that it does not take into account the fact the employees can neither sell the options nor hedge the risk of the option in anyway. Thus using BS overstates the value of the option grant (to the employees) further by not accounting for the personal cost of bearing risk.
2c. How can one adjust the calculations in 1) above to better reflect the value of these options to employees?
While there does not seem to be any fix for the BS assumption of constant volatility, companies often use the shorter “expected” life of the option (say the average of the vesting period and the expiration date) instead of the full 10 years to value the option under BS. This adjustment is needed because the value of ESOs must be lower than options that can be traded or exercised at will. We believe that adjusting the maturity date of the options is a more relevant adjustment than changing any other market parameter.
Instead of using the BS model (which does not allow for early exercise of options), it is more suitable to use a multi-step binomial tree but with the added complexity of checking at each node whether the option is worth more if it is dead (exercised) or alive (not yet exercised) and then using the higher of these two values.
3a. At the time of grant, the options are out of the money, therefore in order to profit from owning the options, managers would need the stock price to rise above strike price. If the stock price does not rise, their options become worthless and they lose the value of the grant. However, with RSUs,

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