UK: Share Price Volatility and Accounting for Share Options

In 2005 for the first time UK listed companies were required to comply with the Share Based Payment International Accounting Standard (IFRS2). This Standard not only requires the financial statements to include an expense for the cost of options and other equity instruments but the assumptions or factors that are used in calculating the cost of options (using a form of option pricing theory such as Black Scholes) also have to be disclosed.

The six factors are:-

1. market value of share at date of grant;
2. exercise price of option;
3. expected life of the option;
4. expected risk free rate;
5. expected dividend yield;
6. expected volatility.

For many companies the assumption about expected volatility is likely to be the most important in determining the size of the accounting expense. As a result of the mathematics of option pricing theory the lower the volatility assumed the lower will be the accounting cost. Although companies are required to forecast their future share price volatility they usually use their historical volatility as a guide to future volatility.

Most of the FTSE 100 companies have now published their 2005 accounts and disclosed their volatility assumptions. These may be summarised as follows.

Generally the distribution of expected volatilities appears to be centred around the mean, with a fairly even spread above and below the mean volatility, as shown below.

There were some interesting variations between sectors, with Insurance companies considering their shares likely to be amongst the most volatile, while recent stock market stars such as the mining and oil sectors expected no more than average or below average future volatilities. The expected volatilities by sector are summarised below.

Overall the volatilities being assumed appear to be somewhat lower than the assumptions about volatility that were prevailing at the time the Standard was being developed. As a result the accounting expense, overall, may prove to be lower than was perhaps generally expected. However, although there are exceptions for individual companies, in general the assumed volatilities do not appear to be out of line with actual volatilities over the last year or so. The lower than expected volatilities would seem to be a reflection of the relative stability of the UK Stock Market during the last few years. Whether this continues to be the case in future, of course, remains to be seen.

Amongst the various forms of option pricing theory Black Scholes was the most popular being used by 41% of companies and in combination with other methodologies by a further 21%. The binominal (or lattice) method was preferred by 16% and Monte Carlo was the favoured method of 6% with a further 16% using a combination of methods including the binominal method and Monte Carlo for different plans within the company.

The volatility assumptions that a company makes in calculating the cost of its options once fixed cannot be changed to take account of subsequent events. However, the assumptions made for future awards can be different. As expected volatility is inherently hard to forecast, and a company's historical volatility is not necessarily a reliable guide to its future volatility, companies may wish to compare their volatility assumptions with those of other comparable companies before making further forecasts of expected volatility.

From 2006, the Standard in its UK domestic equivalent form FRS20 will apply to unlisted companies (including AIM). Unquoted companies will generally be expected to base their expected volatility assumption on the volatilities of comparable quoted companies.

The Pinsent Masons Share Plans Team assists companies to apply the Share Based Payment Standard to their own circumstances and can provide companies with volatility data both on themselves and comparable quoted companies.