This study examines how executives' and lower-level employees' option exercise behavior affects firms' stock option grant cost estimates. Prior research suggests that option grant cost estimates are not materially different when calculated a using utility-based model or a risk-neutral model adjusted for historical exercise rates. This study shows, however, that estimates of exercise times are significantly improved when the model accounts for behavioral and economic determinants of option exercise such as the attainment of performance benchmarks, recent vesting, the intrinsic value of an employee's option portfolio, and employee rank. Hazard analysis of all executive and employee option grants within a proprietary sample of firms yields lower out-of-sample exercise timing prediction errors relative to utility-based models and estimates using historical exercise patterns. More importantly, option cost estimates are materially different when improved estimates of exercise times are used, which may have implications for financial reporting.
