1. Many companies use stock options (which are call options) to incentivize their employees, particularly C-level executives. An accounting rule dating back to 1972 states that these stock options can be expensed at the value of exercise. That is, they can be put as an expense on the balance sheet as the maximum of zero, and the difference between the fair value of the underlying stock and the exercise price of the option.

(A clarification on question 1: Companies often use stock options as a form of compensation. These options are call options in the company with expirations several years from the date of issue. These are an expense to the company (as they represent a transfer from the company to employees). Prior to exercise, companies are allowed to report these as expenses with a value equal to their exercise value. For example, if the company has a share price of $50 and they issue stock options with a strike of $45, they are allowed to expense these at a rate of $5 per option share.)

a) Does this rule over- or under-estimate the expense of stock market options? Explain.

b) Given your answer to (a), do you think that companies are over- or under-incentivized to use option-based methods of compensation?