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