Whichever model a corporation used, the biggest fudge factor in determining value is the volatility assumption. One proposal had surfaced suggesting that one could assume zero volatility.
Have you ever heard of a stock price that never moved?
For example, corporations depreciate expensive factory equipment according to accounting rules.
While depreciation does not precisely capture the exact cost and timing of equipment replacements, it highlights the fact that there is a significant cost to stay in business.
Instead, it used historic prices as the basis on which to calculate volatility when it revalued its options.
The result was astounding; Freddie Mac eliminated 1 million from its 2001 accounting transition adjustment gain (through adoption of a new accounting rule, SFAS133) by choosing an opportunistic methodology for determining volatility.
The rules of depreciation create some ambiguities, but one cannot use this as an excuse to ignore a real cost of doing business.
In his 1985 letter to Berkshire Hathaway shareholders, Warren Buffett challenged those who complain about the ambiguities of valuing employee stock options.
Figuring out exactly what the value of the option is today, before the option vests and before the expiration date, is more difficult.
One has to estimate the probability of a future gain and the timing of a future gain, and it makes sense to come up with a standard way of estimating today’s value.
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Freddie Mac, a corporation chartered by Congress, had come under fire in the first five years of this century for manipulating volatility inputs to its option models, among other accounting issues.