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Hull: Options, Futures, and Other Derivatives, Ninth Edition

Chapter 16: Employee Stock Options


Multiple Choice Test Bank: Questions with Answers
1. Which of the following is true?
A. An employee stock option is usually held to maturity
B. An employee stock option tends to be exercised earlier than an OTC
option with the same terms
C. An employee stock options tends to be exercised later than an OTC
option with the same terms
D. Employee stock options are usually exercised as early as possible
Answer: B
Employee stock options tend to be exercised earlier than similar
exchange-traded options. This is because they cannot be sold and
exercising them is the only way to monetize gains. A, C, and D are not
true.
2. Which
A.
B.
C.
D.

of the following is NOT usually true about employee stock options?


There is a vesting period
They can be sold to other employees
They are often at-the-money when issued
Their value is currently a charge to the income statement

Answer: B
Employee stock options cannot be sold. A, C, and D are true.
3. What term is used to describe losses shareholders experience because the
interests of managers are not aligned with their own?
A. Agency costs
B. Backdating scandals
C. Dilution
D. Income statement expense
Answer: A
Agency costs refers to costs arising because the interests of managers
and shareholders are not aligned.
4. Which of the following are true of employee stock options?
A. They are commonly valued as though they are regular American
B. They are commonly valued as though they are regular American
but with a reduced life.
C. They are commonly valued as though they are regular European
D. They are commonly valued as though they are regular European
but with a reduced life.
Answer: D

options
options,
option
options

They are commonly valued using Black-Scholes-Merton (i.e. as European


options) but with a reduced life to reflect early exercise behavior
5. Which of the following was true about employee stock options prior to 1995?
A. The options never had any affect on a companys financial statements
B. The value of options which were at-the-money when issued had to be
expensed on the income statement
C. The value of options which were at-the-money when issued had to be
reported in the notes to the financial statements
D. Options which were at-the-money when issued did not affect a
companys financial statements
Answer: D
Options which were at the money were assumed to have no cost to a
company prior to 1995.
6. Which of the following was true about employee stock options between 1996
and 2004?
A. The options never had any affect on a companys financial statements
B. The value of options which were at-the-money when issued had to be
expensed on the income statement
C. The value of options which were at-the-money when issued had to be
reported in the notes to the financial statements
D. Options which were at-the-money when issued did not affect a
companys financial statements
Answer: C
The value of options had to be reported in the notes to the financial
statements between 1996 and 2004. They did not have to be expensed.
7. Which of the following was true after 2005?
A. The options never had any affect on a companys financial statements
B. The value of options which were at-the-money when issued had to be
expensed on the income statement
C. The value of options which were at-the-money when issued had to be
reported in the notes to the financial statements
D. Options which were at-the-money when issued did not affect a
companys financial statements
Answer: B
After 2005 options had to be expensed on the income statement.
8. Which of the following is true about employee stock options after they have
been issued?
A. They have to be revalued every year
B. They have to be revalued every quarter

C. They have to be revalued every day like other derivatives


D. They never have to be revalued
Answer: D
Options are valued when issued but do not have to be valued
subsequently.
9. Which of the following is true about the practice of backdating a stock options
grant?
A. It is illegal
B. It is illegal in the majority of states in the U.S., but not all states
C. It is illegal in roughly half the states in the U.S.
D. It is unethical, but not illegal
Answer: A
Backdating is illegal
10.A company surprises the market with an announcement that it has granted
stock options to senior executives. The options are exercised four years later.
When does dilution take place?
A. Dilution takes place when the options are exercised
B. Dilution takes place on the announcement date
C. Dilution takes place gradually over the four years
D. There is no dilution
Answer: B
Efficient markets should ensure that dilution takes place at the time of the
announcement.
11.When an employee leaves the company which of the following is usually true?
A. All outstanding employee stock options are forfeited
B. Out-of the money employee stock options are forfeited
C. All options which have vested are forfeited
D. All options are retained
Answer: B
Usually out-of-the-money options are forfeited and in-the-money options
have to be exercised immediately.
12.Which
A.
B.
C.

of the following defines the vesting period?


The period during which employee stock options can be exercised
The period during which the options are issued
The period during which the strike price of the options equals the stock
price
D. The period during which employee stock options cannot be exercised

Answer: D
The vesting period is the period during which options cannot be exercised.
13.Which of the following is NOT true?
A. Management has an incentive to issue executive stock options after
bad news
B. Management has an incentive to issue executive stock options before
good news
C. Executive stock options encourage management to pursue strategies
that are best for the company in the long run
D. Management have an incentive to time the announcement of good
news just before they plan to exercise their stock options
Answer: C
Executive stock options tend to cause management to have short-term
horizons. A, B, and D are not true. This is because management want to
issue options when the price is low and exercise when the price is high.
14.Which of the following strategies makes no sense?
A. An employee exercises stock options early and
dividends are expected
B. An employee exercises stock options early and
dividends are expected
C. An employee exercises stock options early and
Dividends are expected
D. An employee exercises stock options early and
Dividends are expected.

sells the stock. No


keeps the stock. No
sells the stock.
keeps the stock.

Answer: B
An exchange-traded call option on a non-dividend-paying stock should
never be exercised early. The only reason for exercising an employee
stock option is monetize it. (The option cannot be sold). But to monetize
the option the shares of stock that are obtained must be sold.
15.When a CEO has employee stock options, he or she is in theory motivated to
do which of the following?
A. Take more risk
B. Take less risk
C. Buy some of the companys stock
D. None of the above
Answer: A
If the CEO takes more risk, volatility increases and the options become
more valuable.
16.When an employee stock option is exercised, which of the following is usually

true?
A. The employee pays the market price for the shares and the company
refunds the difference between the market price and the strike price
B. The company or the companys agent buys stock in the market for the
employee
C. The company issues more shares and sells them to the employee for
the strike price
D. The employee cannot immediately sell the shares
Answer: C
When an option is exercised the company issues more shares and sells
them to the employee for the strike price.
17.Which
A.
B.
C.
D.

of the following increases the expected life of employee stock options?


An increase in the vesting period
An increase in employee turnover
A fast growth rate for the stock price
A tendency for employees to exercise earlier than in the past

Answer: A
If the vesting period increases employees must wait longer before they are
allowed to exercise.
18.Which of the following hypotheses was supported by empirical research
covering the 1995 to 2002 period?
A. The grant date for executive stock options tended to be when the stock
price is high
B. The grant date for executive stock options tended to be when the stock
price is low
C. The grant date for executive stock options tended to be after a growth
spurt in the stock price
D. The was no relationship between the timing of grants and the stock
price
Answer: B
Empirical research showed that the grant date was a low point for the
stock price. This was used as evidence for backdating.
19.Which of the following ensures that managers are rewarded only when a
company performs better than its competitors?
A. A constant strike price for executive stock options
B. A strike price that increases with time
C. A strike price that changes in line with an index of stock prices
D. A strike price that is tied to reported profit
Answer: C

If an option is initially at the money and the strike price increases in line
with an index, the company must outperform the index for the option to
move in the money
20.Employee stock options are particularly popular with start ups because
A. They encourage employees to work hard
B. The start up cannot afford to pay high salaries
C. The risk associated with the companys success is shared with
employees.
D. All of the above
Answer: D
A, B, and C are all reasons why employee stock options are attractive to a
start up