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with the expected option term. If a newly listed entity does not have sufficient information
on historical volatility, it should compute historical volatility for the longest period for
which trading activity is available. It should also consider the historical volatility of similar
entities. For example, an entity that has been listed for only one year and grants options
with an average expected life of five years might consider the historical volatility of
entities in the same industry, which are of a similar size and operate similar businesses,
for the first six years in which the shares of those entities were publicly traded. [IFRS 2.B26].
8.5.3.B Unlisted
entities
An unlisted entity will have neither historical nor current market information to
consider when estimating expected volatility. IFRS 2 suggests that, in some cases, an
unlisted entity that regularly issues options or shares might have set up an internal
market for its shares. The volatility of those share prices could be considered when
estimating expected volatility. Alternatively, if the entity has based the value of its shares
on the share prices of similar listed entities, the entity could consider the historical or
implied volatility of the shares of those similar listed entities. [IFRS 2.B27-29].
If the entity has not used a valuation methodology based on the share prices of similar
listed entities, the entity could derive an estimate of expected volatility consistent with
the valuation methodology used. For example, the entity might consider it appropriate
to value its shares on a net asset or earnings basis if this approximates to the fair value
of the equity instruments, in which case it could consider the expected volatility of those
net asset values or earnings. [IFRS 2.B30].
8.5.3.C
Listed entities that have undergone significant restructuring
An issue not specifically addressed by IFRS 2 is the approach required in the case of an
entity that has been listed for some time but which has recently undergone significant
restructuring or refocusing of the business (e.g. as a result of acquisitions, disposals or
refinancing). In such cases, it may well be appropriate to adopt the approach advocated
for newly listed entities in 8.5.3.A above.
8.5.3.D
Expected volatility under the Black-Scholes-Merton formula
In calculating the fair value of a share option using the Black-Scholes-Merton formula, a
single expected volatility assumption must be used. That amount should be based on the
volatility expected over the expected term of the option. Frequently, expected volatility is
based on observed historical share price volatility during the period of time equal to the
expected term of the option and ending on the grant date. Implied volatilities (i.e.
volatilities implied by actual option prices on the entity’s shares observed in the market)
also may be considered in determining the expected volatility assumption (see 8.5.3 above).
When developing an expected volatility assumption, current and historical implied
volatilities for publicly traded options and historical realised share volatilities should be
considered for shares of the grantor and shares of other entities in the grantor’s industry
and comparable entities.
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The volatility of a market index will not generally provide an appropriate input as the
diversified nature of the index tends to produce a lower volatility figure than that
applicable to individual shares.
8.5.3.E
Expected volatility under lattice models
Expected volatility is more accurately taken into account by lattice models than by the
Black-Scholes-Merton formula, because lattice models can accommodate dynamic
assumptions regarding the term structure and path-dependence of volatility. For
example, there is evidence that volatility during the life of an option depends on the
term of the option and, in particular, that short-term options often exhibit higher
volatility than similar options with longer terms. Additionally, volatility is path-
dependent, in that it is often lower (higher) after an increase (decrease) in share price.
An entity that can observe sufficiently extensive trading of options over its shares may
decide, when developing a term structure of expected volatility, to place greater weight
on current implied volatilities than on historical observed and implied volatilities. It is
likely that current implied volatilities are better indicators of the expectations of market
participants about future volatility.
8.5.4 Expected
dividends
The valuation of an award of options depends on whether or not the holder is entitled
to dividends or dividend equivalents (whether in the form of cash payments or
reductions in the exercise price) before the award is ultimately exercised.
[IFRS 2.B31-32, B34]. The accounting treatment of awards that entitle the holder to
dividends before exercise is discussed further at 15.3 below.
Dividends paid on the underlying share will impact the share option value – the higher
the expected dividend yield (i.e. dividend per share ÷ share price), the lower the option
value. Option holders generally do not have dividend rights until they actually exercise
the options and become shareholders. All other things being equal, a share option for a
share yielding a high dividend is less valuable than one for a share yielding a low dividend.
Where employees are entitled to dividends or dividend equivalents, the options granted
should be valued as if no dividends will be paid on the underlying shares, so that the
input for expected dividends (which would otherwise reduce the valuation of an option)
is zero. Conversely, where employees are not entitled to dividends or dividend
equivalents, the expected dividends should be included in the application of the pricing
model. [IFRS 2.B31-32, B34].
While option pricing models generally call for an expected dividend yield, they may be
modified to use an expected dividend amount rather than a yield. Where an entity uses
expected payments rather than expected yields, it should consider its historical pattern
of increases in dividends. For example, if an entity’s policy has generally been to
increase dividends, its estimated option value should not assume a fixed dividend
amount throughout the life of the option unless there is evidence to support that
assumption. [IFRS 2.B35].
Determination of the expected dividends over the expected term of the option requires
judgement. Generally, the expected dividend assumption should be based on current
expectations about an entity’s anticipated dividend policy. For example, an entity that
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has demonstrated a stable dividend yield in past years, and has indicated no foreseeable
plans to change its dividend policy, may simply use its historical dividend yield to
estimate the fair value of its options. If an entity has never paid a dividend, but has
publicly announced that it will begin paying a dividend yielding 2% of the current share
price, it is likely that an expected dividend yield of 2% would be assumed in estimating
the fair value of its options.
Generally assum
ptions about expected dividends should be based on publicly available
information. Thus, an entity that does not pay dividends and has no plans to do so should
assume an expected dividend yield of zero. However, an emerging entity with no history
of paying dividends might expect to begin paying dividends during the expected lives of
its employee share options. Such entities could use an average of their past dividend
yield (zero) and the mean dividend yield of a comparable peer group of entities.
[IFRS 2.B36].
8.5.4.A
Expected dividends under the Black-Scholes-Merton formula
Closed-form option-pricing models generally call for a single expected dividend yield
as an input. That input should be determined based on the guidance at 8.5.4 above.
8.5.4.B
Expected dividends under the binomial model and other lattice models
Lattice models can be adapted to use an expected dividend amount rather than a
dividend yield, and therefore can also take into account the impact of anticipated
dividend changes. Such approaches might better reflect expected future dividends,
since dividends do not always move in a fixed fashion with changes in the entity’s share
price. This may be a time- or price-dependent assumption, similar to those described
in the discussion of the binomial model at 8.3.2 above. Expected dividend estimates in
a lattice model should be determined based on the general guidance above.
Additionally, when the present value of dividends becomes significant in relation to the
share price, standard lattice models may need to be amended.
8.5.5
Risk-free interest rate
Typically, the risk-free interest rate is the implied yield currently available on zero-
coupon government issues of the country in whose currency the exercise price is
expressed, with a remaining term equal to the expected term of the option being valued
(based on the remaining contractual life of the option and taking into account the effects
of expected early exercise). It may be necessary to use an appropriate substitute, if no
such government issues exist, or where the implied yield on zero-coupon government
issues may not be representative of the risk-free interest rate (for example, in high
inflation economies). An appropriate substitute should also be used if market
participants would typically determine the risk-free interest rate by using that
substitute. [IFRS 2.B37].
The risk-free interest rate will not have an impact on most free share grants unless the
counterparty is not entitled to dividends during the vesting period and the fair value
of the grant has been reduced by the present value of the dividends. Otherwise, grants
of free shares have an exercise price of zero and therefore involve no cash outflow
for the holder.
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8.5.5.A
Risk-free interest rate under the Black-Scholes-Merton formula
The Black-Scholes-Merton formula expressed at 8.3.1 above uses a continuously
compounded interest rate, which means that any interest rate calculated or obtained needs
to be in this format. The continuously compounded interest rate is given by the formula:
continuously compounding rate = ln(1 + annual rate),
where ln represents a natural logarithm. For example, a 7.79% annual effective rate
results in a continuously compounded rate of 7.50%:
7.50% = ln(1 + 0.0779)
8.5.5.B
Risk-free interest rate under binomial and other lattice models
At each node in the lattice, the option values in the lattice should be discounted using
an appropriate forward rate as determined by a yield curve constructed from the
implied yield on zero-coupon government bond issues. In stable economies this will
have minimal impact and it is therefore likely that a flat risk-free rate that is consistent
with the expected life assumption will be a reasonable estimate for this input.
8.6
Capital structure effects and dilution
Typically, traded share options are written by third parties, not the entity issuing the
shares that are the subject of the option. When these share options are exercised, the
writer delivers to the option holder shares acquired from existing shareholders. Hence
the exercise of traded share options has no dilutive effect. By contrast, when equity-
settled share options written by the entity are exercised, new shares may be issued
(either in form or in substance, if shares previously repurchased and held in treasury are
used), giving rise to dilution. This actual or potential dilution may reduce the share price,
so that the option holder does not make as large a gain on exercise as would be the case
on exercising an otherwise similar traded option that does not dilute the share price.
[IFRS 2.B38-39].
Whether or not this has a significant effect on the value of the share options granted
depends on various factors, such as the number of new shares that will be issued on
exercise of the options compared with the number of shares already issued. Also, if the
market already expects that the option grant will take place, the market may have
already factored the potential dilution into the share price at the date of grant. However,
the entity should consider whether the possible dilutive effect of the future exercise of
the share options granted might have an impact on their estimated fair value at grant
date. Option pricing models can be adapted to take into account this potential dilutive
effect. [IFRS 2.B40-41].
In practice, in our view, it is unlikely that a listed entity would be required to make such
an adjustment unless it makes a very large, unanticipated grant of share options. Indeed,
even in that case, if the potential dilution is material and is not already incorporated into
the share price, it would be expected that the announcement of the grant would cause
the share price to decline by a material amount. Unlisted entities should consider
whether the dilutive impact of a very large option grant is already incorporated into the
estimated share price used in their option-pricing model. If that is not the case, some
adjustment to the fair value may be appropriate.
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8.7 Valuation
of
equity-settled
awards other than options
As noted at 8.1 above, the discussion in 8.3 to 8.5 above may well be relevant to share-
based payments other than options. These include, but are not restricted to:
• awards of shares (see 8.7.1 below);
• non-recourse loans (see 8.7.2 below);
• share appreciation rights (SARs) (see 8.7.3 below); and
• performance rights (see 8.7.4 below).
8.7.1 Shares
IFRS 2 requires shares granted to employees to be valued at their market price (where
one exists) or an estimated market value (where the shares are not publicly traded), in
either case adjusted to take account of the terms and conditions on which the shares
were granted, other than those vesting conditions that IFRS 2 requires to be excluded
in determining the grant date fair value (see 6.2 above). [IFRS 2.B2].
For example, the valuation should take account of restrictions on the employee’s right:
• to re
ceive dividends in the vesting period (see below); or
• to transfer shares after vesting, but only to the extent that such restrictions would
affect the price that a knowledgeable and willing market participant would pay for
the shares. Where the shares are traded in a deep and liquid market, the effect may
be negligible.
The valuation should not, however, take account of restrictions on transfer or other
restrictions that exist during the vesting period and which stem from the existence of
vesting conditions. [IFRS 2.B3].
Whether dividends should be taken into account in measuring the fair value of shares
depends on whether the counterparty is entitled to dividends or dividend equivalents
(which might be paid in cash) during the vesting period. When the grant date fair value
of shares granted to employees is estimated, no adjustment is required if the employees
are entitled to receive dividends during the vesting period (as they are in no different a
position in this respect than if they already held shares). However, where employees
are not entitled to receive dividends during the vesting period, the valuation should be
reduced by the present value of dividends expected to be paid during the vesting period.
[IFRS 2.B31, B33-34]. The basis on which expected dividends during the vesting period
might be determined is discussed in the context of the impact of expected dividends on
the fair value of share options at 8.5.4 above.
The accounting treatment of awards which give the right to receive dividends or
dividend equivalents during the vesting period is discussed further at 15.3 below.
8.7.2 Non-recourse
loans
Non-recourse loans are loans granted by an entity to the employee to allow the
employee to buy shares, and are discussed in more detail at 15.2 below. Generally,
however, the loan is interest-free, with the dividends received on the purchased shares
being used to repay the loan. The loan acts like an option, in that, at the point in time
when the holder decides to sell the shares to repay the loan, if the shares are worth less
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than the loan, the remaining part of the loan is forgiven, with the effect that, just as in
the case of an option, the holder bears no risk of ownership.