Follow
Publications: 136 | Followers: 0

Employee Stock Options - cbafaculty.org

Publish on Category: Birds 0

Fundamentals of Futures and Options Markets, 9th Ed,Ch14, Copyright © John C. Hull 2016
Employee Stock Options
Chapter 14
1
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
2
Nature of Employee Stock Options
Employee stock options are call options issued by a company on its own stockThey are often at-the-money at the time of issueThey often last as long as 10 years
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
3
Typical Features of Employee Stock Options(page 319)
There is a vesting period during which options cannot be exercisedWhen employees leave during the vesting period options are forfeitedWhen employees leave after the vesting period in-the-money options are exercised immediately and out of the money options are forfeitedEmployees are not permitted to sell optionsWhen options are exercised the company issues new shares
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
4
Exercise Decision
To realize cash from an employee stock option the employee must exercise the options and sell the underlying sharesEven when the underlying stock pays no dividends, an employee stock option (unlike a regular call option) is often exercised early
Drawbacks of Employee Stock Options
Gain to executives from good performance is much greater than the penalty for bad performanceExecutives do very well when the stock market as a whole goes up, even if their firm does relatively poorlyExecutives are encouraged to focus on short-term performance at the expense of long-term performanceExecutives are tempted to time announcements or take other decisions that maximize the value of the options
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
5
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
6
Accounting for Employee Stock Options
Prior to 1995 the cost of an employee stock option on the income statement was its intrinsic value on the issue dateAfter 1995 a “fair value” had to be reported in the notes (but expensing fair value on the income statement was optional)Since 2005 both FASB and IASB have required the fair value of options to be charged against income at the time of issue
Traditional At-the-Money Call Options
The attraction of at-the-money call options used to be that they led to no expense on the income statement because they had zero intrinsic value on the exercise dateOther plans were liable to lead an expenseNow that the accounting rules have changed some companies are considering other types of plans
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
7
Nontraditional Planspage 322
Strike price is linked to stock index so that the company’s stock price has to outperform the index for options to move in the moneyStrike price increases in a predetermined wayOptions vest only if specified profit targets are met
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
8
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
9
Valuation of Employee Stock Options
Alternatives:Use Black-Scholes-Merton with time to maturity equal to an estimate of expected life (there is no theoretical justification for the time to maturity adjustment but it does not seem to work too badly in practice)Use a more sophisticated approach involving binomial trees
Example of the Use of Black-Scholes-Merton(Example 14.1, page 323)
A company issues one million10-year ATM optionsstock price is $30.It estimates the long term volatility using historical data to be 25% and the average time to exercise to be 4.5 yearsThe 4.5 year interest rate is 5% and dividends during the next 4.5 years are estimated to have a PV of $4Using BSM withS0=26,K=30,r=5%,s=25%, andT=4.5 years gives value of each option equal to $6.31The income statement expense would be $6.31 million
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
10
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
11
Dilution
Employee stock options are liable to dilute the interests of shareholders because new shares are bought at below market priceHowever this dilution takes place at the time the market hears that the options have been granted (Business Snapshot 14.1)It does not take place at the time the options are exercised
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
12
Backdating
Backdating appears to have been a widespread practice in the United StatesA company might take the decision to issue at-the-money options on April 30 when the stock price is $50 and then backdate the grant date to April 3 when the stock price is $42Why would they do this?
Academic Research Exposed Backdating(See research by Yermack, Lie, and Heron)
Fundamentals of Futures and Options Markets, 9th Ed, Ch 14, Copyright © John C. Hull 2016
13
Academics have shown that stock prices on grant dates are on average lower than on the subsequent 30 daysThis could not have happened by chance and led the SEC to require stock option grants to be reported within two business days of the grant date.Backdating has led to numerous lawsuitsWho loses and who gains when grants are backdated?

0

Embed

Share

Upload

Make amazing presentation for free
Employee Stock Options - cbafaculty.org