ch 14 hull fundamentals 8 the d

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Fundamentals of Futures and Options Markets, 8th Ed, Ch 14, Copyright © John C. ull!"1#

Employee Stock Options

Chapter 14

1



Fundamentals of Futures and Options Markets, 8th Ed, Ch 14, Copyright © John C. ull !"1#2

Nature of Employee Stock Options

Employee stock options are calloptions issued by a company on its

own stockThey are often at-the-money at the

time of issue

They often last as long as 10 years




Typical Features of Employee

Stock Options (page 324)

There is a vesting period during which optionscannot be exercised

hen employees leave during the vesting period

options are forfeited hen employees leave after the vesting period in-

the-money options are exercised immediately andout of the money options are forfeited

Employees are not permitted to sell options hen options are exercised the company issues

new shares




Exercise Decision

To reali!e cash from an employee stockoption 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 oftenexercised early



Dra!acks of Employee Stock

Options

%ain to executives from good performance is muchgreater than the penalty for bad performance

Executives do very well when the stock market as awhole goes up" even if their firm does relatively poorly

Executives are encouraged to focus on short-termperformance at the expense of long-term performance

Executives are tempted to time announcements or takeother decisions that maximi!e the value of the options





"ccounting for Employee Stock

Options

&rior to 1''( the cost of an employee stockoption on the income statement was its intrinsicvalue on the issue date

)fter 1''( a *fair value+ had to be reported inthe notes #but expensing fair value on theincome statement was optional$

,ince 00( both .),/ and ),/ have reuiredthe fair value of options to be charged againstincome at the time of issue



Tra#itional "t$t%e$&oney 'all

Options

The attraction of at-the-money call optionsused to be that they led to no expense onthe income statement because they had!ero intrinsic value on the exercise date

2ther plans were liable to lead an expense3ow that the accounting rules have

changed some companies are consideringother types of plans




Nontra#itional lans page 32

,trike price is linked to stock index sothat the companys stock price has to

outperform the index for options tomove in the money

,trike price increases in a

predetermined way2ptions vest only if specified profit

targets are met





*aluation of Employee Stock

Options

)lternatives5 6se /lack-,choles-7erton with time to

maturity eual to an estimate of expected life#there is no theoretical 8ustification for thetime to maturity ad8ustment but it does notseem to work too badly in practice$

6se a more sophisticated approach involvingbinomial trees



Example of t%e +se of ,lack$

Sc%oles$&erton (Example -./-0 page 321)

) company issues one million10-year )T7 options stock price is 9:0; t estimates the long term volatility using historical data to be

(< and the average time to exercise to be 4;( years The 4;( year interest rate is (< and dividends during the

next 4;( years are estimated to have a &= of 94

6sing /,7 with S 0 >?" K >:0" r >(<" σ>(<" and

T >4;( years gives value of each option eual to

9?;:1 The income statement expense would be 9?;:1

million





Dilution

Employee stock options are liable to dilutethe interests of shareholders because newshares are bought at below market price

@owever this dilution takes place at the timethe market hears that the options have beengranted #/usiness ,napshot 14;1$

t does not take place at the time the optionsare exercised




,ack#ating

/ackdating appears to have been awidespread practice in the 6nited ,tates

) company might take the decision toissue at-the-money options on )pril :0when the stock price is 9(0 and thenbackdate the grant date to )pril : whenthe stock price is 94

hy would they do thisA



"ca#emic esearc% Expose# ,ack#ating(See Eric ies e! site5 /!i6/uioa/e#u7faculty7elie7!ack#ating/%tm


ch 14 hull fundamentals 8 the d

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