Employee Reload Options: Pricing, Hedging, and Optimal Exercise

Reload options, call options whose exercise entitles the holder to new options, are compound options that are commonly issued by firms to employees. Although reload options typically involve exercise at many dates, the optimal exercise policy is simple (always exercise when in the money) and surprisingly robust to assumptions about the employee’s ability to transact in the underlying stock as well as assumptions about the underlying stock price and dividend processes. As a result, we obtain general reload option valuation formulas that can be evaluated numerically. Furthermore, under the Black-Scholes assumptions with or without continuous dividends, there are even simpler formulas for prices and hedge ratios. With time vesting, valuation and optimal exercise are computed in a trinomial model, and we provide useful upper and lower bounds for the continuous-time case. ∗Washington University in St. Louis, John M. Olin School of Business, Campus Box 1133, One Brookings Drive, St.Louis, MO 63130-4899, [email protected] or [email protected]. We would like to thank Jennifer Carpenter, Ravi Jagannathan, and seminar participants at the City University in Hong Kong, DePaul University, NYU, and Washington University, and two anonymous referees for their comments. We are responsible for any errors.