In this article, we consider the implications of increasing interest rates for companies offering share options as an employee payment vehicle either instead of cash salary, or as an incentive.

For inflation’s impact on other aspects of executive pay, see our prior article HERE.

Options are typically valued and allocated to executives using the Black-Scholes model. Two key inputs in option valuation models are the risk-free interest rate and expected volatility. The higher the interest rate and volatility, the more expensive the option will be.

This means that for an equivalent dollar grant value, the executive will be granted fewer options.

The risk-free rate estimate is typically based on the yield on government bonds with maturity equal to the life of the option.

As shown in the figure below, the 3-year government bond yield started to increase well before the RBA’s decision to increase the interest rate on 3 May. That is, bond markets already expected rate increases this year.

Figure 1: RBA 3-year zero coupon bond yield over the past 12 months

To estimate expected volatility for option valuation purposes, a starting point is often the historical volatility for the share price over a period equal to the life of the option. With increased uncertainty from high inflation and further interest rate increases on the cards, volatility in share markets have also increased and may stay at an elevated level.

The table below shows the number of options in lieu of a share grant at various volatilities and interest rates, assuming an exercise price equal to the share price and option life of 3 years.

Table 1: The number of options an executive would get for the value of one share

At a risk-free interest rate of 0% and volatility of 20%, an employee would receive 7.27 options per share for an equivalent grant value. At a risk-free rate of 4% and volatility of 40%, an employee would receive 3.17 options per share for an equivalent grant value. That is, the employee will be granted 56% fewer options due to higher interest rates and volatility.

Therefore, it is a double whammy for option grants in a high inflation environment. Bond yields are expected to increase from a hawkish RBA. Share price volatility may also increase for the near future as the market adjusts to the inflationary environment.

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