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Lecture 4: Employee Stock Options

Alonso Peña, SDA Professor
Banking and Insurance Department
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Part 1:
Part 2:
Case Study

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2 2

Part 1: Introduction

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Stock Options

An employee stock option is a call option on the common
stock of a company, issued as a form of noncash compensation.
Restrictions on the option (such as vesting and limited
transferability) attempt to align the holder's interest with
those of the business' shareholders

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protocollo xxxx 5 5 . especially by businesses that are not yet profitable.Introduction Stock Options Definition If the company's stock rises. This gives employees an incentive to behave in ways that will boost the company's stock price. holders of options experience a direct financial benefit. Employee stock options are mostly offered to management as part of their executive compensation package. They are also offered to other staff. Copyright SDA Bocconi.

often the company's current stock price. a company issues vested or non-vested ESOs to an employee which are struck at a particular price.Introduction Stock Options Overview Employee stock options (ESO) are non-standardized. overthe-counter options that are issued as a private contract between the employer and employee. Over the course of employment. protocollo xxxx 6 6 . Copyright SDA Bocconi.

protocollo xxxx 7 7 . obligating the company to sell the employee its stock at whatever stock price was used as the strike price.Introduction Stock Options Overview Depending on the vesting schedule and the maturity of the options. At that point. the employee may either sell the stock or hold on to it in the hope of further price appreciation. the employee may elect to exercise the options before maturity. Copyright SDA Bocconi.

Alternatively. a formula may be used. Quantity: Standardized stock options typically have 100 shares per contract. Often. such as sampling the lowest closing price over a 30-day window on either side of the grant date. protocollo xxxx 8 8 . ESOs usually have some nonstandardized amount. an employee may have ESOs struck at different times and different strike prices. Copyright SDA Bocconi.Introduction Stock Options Differences with exchange-traded options Strike: The strike price is non-standardized and is often the current price of the company stock at the time of issue.

while standardized options usually have a maximum maturity of about 30 months. protocollo xxxx 9 9 .Introduction Stock Options Vesting: Often the number of shares available to be exercised at the strike price will increase as time passes according to some vesting schedule. It is not unusual for ESOs to have a maturity of 10 years from date of issue. Duration: ESOs often have a maturity that far exceeds the maturity of standardized options. Copyright SDA Bocconi. . Vesting only occurs during the duration of the employment.

Introduction Stock Options Non-transferable: With few exceptions. Over the counter: Unlike exchange traded options. Copyright SDA Bocconi. ESOs are considered a private contract between the employer and employee. As such. ESOs are generally not transferable and must either be exercised or allowed to expire worthless on termination of employment. protocollo xxxx 1010 . those two parties are responsible for arranging the clearing and settlement of any transactions that result from the contract.

If for any reason the company is unable to deliver the stock against the option contract upon exercise. Copyright SDA Bocconi. protocollo xxxx 1111 . the employee may have limited recourse. For exchange-trade options.Introduction Stock Options In addition. the fulfillment of the option contract is guaranteed by the credit of the exchange. the employee is subjected to the credit risk of the company.

Introduction Stock Options Tax issues: There are a variety of differences in the tax treatment of ESOs having to do with their use as compensation. protocollo xxxx 1212 . ESOs are tax-disadvantaged with respect to standardized options. These vary by country of issue but in general. Copyright SDA Bocconi.

Often. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. are also used for ESOs. protocollo xxxx 1313 . and the appropriate interest rate to use. such as BlackScholes and the binomial model. the only inputs to the pricing model that cannot be readily determined is the estimate of future realized volatility on the underlying.Introduction Stock Options Valuation The value of an ESOs closely follows the valuation techniques used for standardized options. The same models used in valuing standardized options.

protocollo xxxx .Part 2: Case Study Copyright SDA Bocconi.

Knowing that Zentrum was offering an outright salary of $550. Copyright SDA Bocconi. * These selections are from: John Marthinsen..000 in outright salary and $200.S. an equally important U.000 worth of stock options. spent nine months identifying the scientist it wanted to head corporate-wide research and development activities. Risk Takers: Uses and Abuses of Financial Derivatives (2nd Edition).Cse Study Helvetia Holding job offer* Helvetia Holding. 2008.000: $400. but the candidate was also being pursued by Zentrum Inc. Massachusetts.000. Addison Wesley. Chapter 2. a pharmaceutical company located in Boston. protocollo xxxx 1515 . 2 edition. pharmaceutical company located just minutes away. Helvetia countered with a total compensation package worth $600.

because she found Zentrum's deal to be financially more attractive. You might ask: "How can two people put such different values on something so seemingly cut and dried as an option's price?" Copyright SDA Bocconi.Cse Study Helvetia Holding job offer Imagine the surprise of Helvetia's human resources chief if the scientist turned down Helvetia's offer. protocollo xxxx 1616 .

protocollo xxxx 1717 . let's roll back the clock to the day before Helvetia made its employment offer. Copyright SDA Bocconi. Helvetia's assistant treasurer. Imagine that the following conversation between Daniel Weiss. and Tom Benson. It is highly likely that the director of human resources understood very well the benefits. but he had no idea how to value them.Cse Study Helvetia Holding job offer To understand the answer to this question. For that he relied on Helvetia's treasury department. risks. Helvetia's human resources chief. costs. and returns of call options. took place the day before the offer was made.

risk-free interest rate. The price of any option depends on six major factors: current share price. expected share price volatility. Daniel. as quickly as possible. and expected dividends . maturity. but I need to know. and how long do you think it will take you to figure this out? Tom Benson: I'd be glad to help.Cse Study Helvetia Holding job offer Daniel Weiss: Tom. it will take me only a minute or so to enter the information into my computer and figure out the market price of the option. and once we agree on a few details. . protocollo xxxx 1818 . . Copyright SDA Bocconi. but first I need some information from you. the market price of a call option on a Helvetia share. thank you for coming on such short notice. the exercise (or strike) price. Can you help me.

protocollo xxxx 1919 . atthe-money call option. I came prepared with most of this information. Daniel Weiss: All right. then you want to price a five-year.Cse Study Helvetia Holding job offer . but I need to know from you the maturity and strike price. Copyright SDA Bocconi. Let me just summarize in the next table the six variables we will be using in our calculations. That's all I needed to know. just to make sure that what I am entering into my computer is transparent to you. Helvetia's current share price is $50. . so could you tell me the price of a five-year call option that has a $50 strike price? Tom Benson: Fine. .

75% Dividends: $0 Copyright SDA Bocconi. protocollo xxxx 2020 .Cse Study Helvetia Holding job offer Black Scholes input data: Current share price: $50 Strike price: $50 Maturity: 5 years Volatility: 35% Risk free interest rate: 4.

Cse Study Copyright SDA Bocconi. protocollo xxxx Helvetia Holding job offer 2121 .

an at-the-money call option should have a market price of $27. Daniel Weiss: OK. could you tell me the price of a 10-year call option with the same $50 strike price? Tom Benson: With a 10-year maturity. protocollo xxxx 2222 . Copyright SDA Bocconi. That was much easier than I thought it would be. Give me just a second to write down this information. Thanks for your help.Cse Study Helvetia Holding job offer Daniel Weiss: Just for comparison sake.84. Tom.

and he wanted to compensate Smith with $200.T. Copyright SDA Bocconi. and head of R&D at BioPharm Associates in Wellesley. five-year stock option was worth $19. a research professor at M. The next morning. then the compensation package should include 10. Daniel Weiss could now make his offer to Jennifer Smith. if an at-the-money.Cse Study Helvetia Holding job offer Armed with this knowledge.49. As he explained the offer to her. Weiss rounded the offer at 10. he called Jennifer Smith and made his offer.000 worth of stock option benefits. Weiss stressed that Smith would get raises each year and additional stock options in proportion to her salary.262 stock options To ease the math and sweeten the deal. Massachusetts. Weiss figured that.I.500 call options. protocollo xxxx 2323 .

she had already accepted Zentrum's contract.000? Weiss asked Smith if he could call her later that day. Copyright SDA Bocconi. protocollo xxxx 2424 . How could Helvetia's offer of over $600. .Cse Study Helvetia Holding job offer It took Smith only a day to come to the conclusion that Helvetia's offer was not as financially attractive as Zentrum's offer. and by the time she called Daniel Weiss.000 not be as attractive "financially" as a competing offer for $550. Weiss was staggered. . He was so sure she would accept his offer that he had already notified the CEO to include her name in Helvetia's organization chart.

Daniel. Daniel Weiss: I have Tom Benson on the line with me. You will remember that Mr. Did I tell you that we used the Black-Scholes formula to do our valuation? Copyright SDA Bocconi. we are very disappointed to have lost you to our competitor. and I'm happy with my decision. but no. protocollo xxxx 2525 . Smith. Benson helped me value your stock options. I've accepted the Zentrum offer. just so he can help me piece together what went wrong. Are you sure there is nothing we can do to change your mind? Jennifer Smith: Thank you.Cse Study Helvetia Holding job offer Daniel Weiss: Dr.

Jennifer Smith: I realize you both must think I'm crazyespecially when Nobel prizes were given to the gentlemen who discovered and developed the Black-Scholes formula. Thank you for allowing me to be a part of this conversation. Smith. protocollo xxxx 2626 . but all I can say is that what the formula says Helvetia's options should be worth is not what I feel they are worth to me. Weiss in understanding how you arrived at your decision. I'm as interested as Mr.Cse Study Helvetia Holding job offer Tom Benson: Hello. Dr. Here's how I arrived at my conclusion… Copyright SDA Bocconi.

I phoned an old friend. Copyright SDA Bocconi. John. The first question I asked him was if there was any way I could lock-in immediately the $200.000 of stock option compensation that Helvetia was offering. and he sorted out some of the technical details for me. protocollo xxxx 2727 . John and I met last night for dinner.Cse Study Helvetia Holding job offer Jennifer Smith: First. After our call yesterday. let me preface my remarks by admitting that I had some help making up my mind. who is now teaching at a nearby college. Daniel.

One way to lock in the value of the options would be to sell short the Helvetia shares-which I now understand means that I would have to borrow shares. protocollo xxxx 2828 . What was his answer? Jennifer Smith: He explained that my call options gave me the right to buy Helvetia shares for $50 any time after the three-year vesting period. and agree to pay them back in the future. sell them at the current market price.Cse Study Helvetia Holding job offer Daniel Weiss: That sounds logical enough. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

What you would be doing is just the opposite: selling Helvetia shares today and then buying them in five years at the price guaranteed by your stock options. Usually. I think in terms of buying something today and then selling it in the future at a higher price.Cse Study Helvetia Holding job offer Daniel Weiss: I've heard of short selling but never really understood what it meant. protocollo xxxx 2929 . when I think of someone making a profit. Copyright SDA Bocconi. It's sort of like closing the loop-selling now and then buying later.

would it be legal or ethical to sell short Helvetia's shares in this way? Copyright SDA Bocconi. government bond). My Helvetia options had five-year maturities. Dr. Daniel Weiss: But. I'd have to invest the funds in a safe asset (like a U. protocollo xxxx 3030 . Smith. so I based all of my calculations on investing the funds until maturity.Cse Study Helvetia Holding job offer Jennifer Smith: Exactly! But once I sold the shares short and collected the proceeds.S.

Cse Study Helvetia Holding job offer Jennifer Smith: Imagine my surprise when I found out that. Now I remember discussing this issue with our corporate counsel. Section 16-C of the 1934 U.S. If my memory is correct. Daniel Weiss: Ah. yes. There could also be insider-trading issues Copyright SDA Bocconi. protocollo xxxx 3131 . Securities and Exchange Act prohibits officers and directors from selling shares in their companies if they do not already own the securities. there are rules in the United Sates that put tight restrictions on short sales of stocks by employees. even if I wanted to. Apparently. I could not sell short the Helvetia shares.

Cse Study Helvetia Holding job offer Jennifer Smith: Yes. I figured that the most I could lock in-assuming Helvetia shares rose in value.100. and to do that. protocollo xxxx 3232 . I'd have to wait five years! Here's how I did my calculations. Copyright SDA Bocconi. but Daniel. which I'm sure they will-would be only about $137. my main point is that even if I could short the Helvetia shares. that's true.

I'd receive $525.000. if Helvetia's share price rose above $50.S.109 remaining. At the end of the five years.75%.75% would grow to $662. and have $137. protocollo xxxx 3333 .500 shares that I borrowed. so $525.Cse Study Helvetia Holding job offer Jennifer Smith: If I sold short 10. I would exercise my options. which then I could invest for five years. a five-year U. Currently.109 in five years. government bond yields 4.000 invested at a compound annual rate of 4. spend $525. Copyright SDA Bocconi.500 Helvetia shares at $50 per share.000 to buy back and return the 10.

protocollo xxxx Helvetia Holding job offer 3434 .Cse Study Copyright SDA Bocconi.

but. protocollo xxxx 3535 . you have been very thorough. patient. and we were offering you a degree of uncertainty? Did you consider that the uncertainty of our offer also contained the opportunity to strike it rich and become a millionaire? Copyright SDA Bocconi.000 more than Zentrum but for you to feel that the Zentrum offer was financially more attractive? Is it just because Zentrum was offering you a sure thing. some time today. and generous with your time. so please answer for me just one question. Smith. I'm going to have to explain to my boss how we lost you. How was it possible for Helvetia to offer you over $50.Cse Study Helvetia Holding job offer Daniel Weiss: Dr.

Cse Study Helvetia Holding job offer Jennifer Smith: I can assure you that becoming a millionaire didn't escape my attention. but the fundamental problem I had with Helvetia's offer. your offer came up short. protocollo xxxx 3636 . Copyright SDA Bocconi. was that the price you put on the options was not equal to the value I put on them. Even after figuring in the advantage I would have over anyone outside the company with regard to timing the exercise of my options.

Jennifer Smith: My second major question last night to John was: "What is this Black-Scholes formula. Benson and I-did not put an arbitrary price on the options. and how is it coming up with an option price that seems so out of whack with my instincts?" Its precision alone was unnerving. I have always thought that it was considered widely to be an unbiased and highly accurate way of valuing options. We used the BlackScholes formula. Any formula … Copyright SDA Bocconi.Cse Study Helvetia Holding job offer Daniel Weiss: We-and by "we" I mean Mr. protocollo xxxx 3737 . which is used by virtually everyone.

49 made me skeptical-or should I say. protocollo xxxx 3838 . I asked myself whether the difference was large enough to nullify the $50.000 advantage of Helvetia's offer. and at the end. It was a simple plus and minus evaluation. All I wanted to know was whether the assumptions behind the Black-Scholes formula made Helvetia's options look more desirable or less desirable to me. in the course of one evening. nervous. Copyright SDA Bocconi. As a scientist. I knew that the Black-Scholes formula had to be based on a set of .. For me. so I accepted the Zentrum offer. I also knew that. the Helvetia offer came up short. so I took a simpler and more direct route.Cse Study Helvetia Holding job offer … that says an option should be worth exactly $19. I had no chance of understanding all the intricacies of option pricing models.

Jennifer Smith: Here's what I discovered from John. John said that you probably based your option prices on past market statistics. protocollo xxxx 3939 . nontransferable. plugged the six important parameters into the Black-Scholes formula. I am doubly disappointed that you will not be working with us. Now.Cse Study Helvetia Holding job offer Daniel Weiss: I find it amazing that you did all this work in one evening. like Helvetia was offering me. long-term options. and assumed that these factors would remain constant over the maturity of my options. Copyright SDA Bocconi. short-term options rather than non-tradable. The Black-Scholes formula was designed for tradable.

Cse Study Helvetia Holding job offer Daniel Weiss: Yes. you turned down our offer. Jennifer Smith: Well. my options could be worth either far more or far less than the Black-Scholes formula estimated. Daniel Weiss: I understand. You questioned not only the factors we entered into the formula but also their stability over time. Copyright SDA Bocconi. protocollo xxxx 4040 . That is exactly what we did. I figured that. with just slight modifications in your assumptions and their constancy over time. and because of this risk.

I now understand why volatility is important to option pricing. but we have just come out of a tumultuous economic and political period. Daniel Weiss: What is your prediction about the future? Copyright SDA Bocconi. for instance. it lowered their value to me.Cse Study Helvetia Holding job offer Jennifer Smith: Take volatility. This increased volatility raised the BlackScholes price of the options you offered me. protocollo xxxx 4141 . but curiously.

but I don't see how increased volatility and uncertainty help me. Daniel and Tom. because the period of time when I would be allowed and want to exercise them might coincide with a gigantic dip in the share price. I anticipate calmer conditionswhich mean lower volatility-and my expectations have a bizarre. Sorry. It lowers their Black-Scholes price but raises their value to me. so I could exercise them in three to five years at a profit. Increased volatility is a threat to me. reverse effect on the price of Helvetia's options. Who knows? Copyright SDA Bocconi. For me to place a higher value on Helvetia options. I would need to believe that they would grow at a steady positive rate. protocollo xxxx 4242 .Cse Study Helvetia Holding job offer Jennifer Smith: Looking forward.

Cse Study Helvetia Holding job offer Daniel Weiss: Dr. I'm sure I would have enjoyed working at Helvetia. Smith. but it may take some time for me to digest it all. openness. on behalf of Mr. Copyright SDA Bocconi. Benson and me. This conversation has been a real eye-opener for me. and honesty. protocollo xxxx 4343 . Jennifer Smith: It was my pleasure. I want to thank you for your time.