Lattice Option-Pricing Model

Responding to investors and other parties who seek to improve the current accounting standards relating to employee stock compensation in financial statements, FASB released an Exposure Draft on March 31, 2004, with proposals to improve existing accounting rules and provide more detailed information to investors.

Current guidelines require that employee stock options only be disclosed in the footnotes of financial statements. Under the proposed guidelines, however, such transactions would be accounted for using a fair-value-based method, and such compensation costs would be recognized in financial statements. Companies would then be required to treat the ESO the same as other forms of compensation by identifying the related cost in the income statement and would be generally measured at fair value at the grant date.

Although some investors are concerned that the fair value of employee share options cannot be measured with sufficient reliability for recognition in financial statements, the board concluded that it could be calculated dependably with certain option-pricing models.

FASB noted that the Black-Scholes formula and other closed-form models do not produce reasonable estimates of the fair value. FASB believes that the “Lattice” model, unlike the Black-Scholes, is more preferable since it offers the flexibility needed to reflect the distinctive uniqueness of ESO’s and similar instruments.

With FASB’s potential mandate in mind, Montgomery Investment Technology developed the Lattice Option-Pricing Illustrated to show companies exactly how the option-pricing model fundamentally works. By plugging in numbers for company-specific variables such as the underlying price, expected volatility and interest rate, users can immediately evaluate the resulting data in a colorful, user-friendly chart.

For a free demonstration of MITI’s option-pricing tools visit:

OPTIONS XL Binomial Lattice

OPTIONS XL Flexible Binomial Lattice

OPTIONS XL Binomial Lattice Illustrated

FAS123 Toolkit

OPTIONS XL Binomial Lattice Illustrated Online (requires IE and Excel)

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