As many of you read this, the Reserve Bank of Australia is deliberating on whether to move interest rates. 

So, it may be too late to grant executive share options before interest rates increase.  For many, an increase in interest rates will either mean fewer executive share options or a greater bottom line expense to the company. 

The risk free rate of interest is one of the inputs into option valuation models.  It is equivalent to the government bond rate.  This rate increases when the Reserve Bank of Australia increases interest rates.  As the risk free rate increases, so too does the option valuation (assuming other inputs are held steady).  The option valuation is used to determine how many options an executive will receive, as well as the expense charged to the company’s P&L account.

So, for executives who are to receive options equal to a set $ value or percentage of salary, the number of options equal to that amount will literally decrease overnight.  Alternatively, for companies where the executives have been promised a certain number of options, the expense that they will incur will increase overnight.

What will be the magnitude of the impact an increase in official rates has on the valuation and therefore expensing of option grants?  The answer, as usual, is “it depends”.  Most mining companies won’t have much to worry about, but the property sector could see more significant increases.

The following graph shows the percentage increase in the valuation of a five-year option over a $10 share if the risk free rate increases from 6.5% to 6.75% after the Reserve Bank’s 6 November 2007 board meeting.  It indicates that for low yield, high volatility shares the option valuation would increase as little as 1%.  However, for high yield, low volatility stock, the increase could reach almost 3%.

Performance criteria, forfeiture and sub-optimal exercise behaviour were ignored.

The reason that the high volatility shares are affected less than low volatility shares is because the volatility has a greater impact on the valuation as it increases, swamping the effect of the interest rate.  Table 1 shows the actual valuation amounts.

Perhaps the executives impacted should try to make up the difference with a punt on the Melbourne Cup?

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