LETTERS TO THE EDITOR: FASB in error on options valuation
By Janet Tavakoli
Financial Times Apr 05, 2004

From Ms Janet Tavakoli.

Sir, Your article “FASB unveils options proposals” (April 1) highlights a positive step forward in understanding the true costs of running a corporation, but misses a critical flaw in the Financial Accounting Standards Board’s recommendations. Stock options are costs. If corporations want to use stock options as a form of compensation, treating them as an expense will focus corporate managers on whether the hit to reported earnings is justified by the perceived benefits of increased employee stock ownership.

Detractors claim option valuation models are inadequate. It is true the Black-Scholes model has deficiencies in valuing long-dated stock options. The FASB got it partly right in recommending the Binomial model for valuing options. It provides flexibility for doing scenario analyses on corporate earnings. Despite this, the FASB overlooked the crucial step in valuing options. Whatever model is used, the assumption that is most critical is the volatility assumption.

Freddie Mac recently came under criticism for manipulating volatility inputs to its option models. You will recall that Freddie Mac altered a volatility assumption in its swaptions portfolio valuation. It decided that implied volatility from current market prices did not reflect fair value. Instead, it used historic implied volatility to revalue the swaptions. Freddie Mac eliminated $731m from its 2001 accounting transition adjustment gain – through adoption of SFAS133 – by choosing an opportunistic methodology for determining volatility.

Sound financial calculations generate results that are both internally consistent and reproducible across corporations. The FASB will have to set out guidelines for calculating the assumed volatility used in the models, or the results will be subject to opportunistic gaming to manipulate reported earnings.

Janet Tavakoli, President, Tavakoli Structured Finance, Chicago, IL 60601, US

See also: “Madoff Deserves Lots of Company“