Introduction to Options and Futures

Options
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
¡ Apply the Black & Scholes options pricing
framework
¡ Value options as part of your compensation
package
¡ Think hard about a few real-world
complications that the “textbook” model
ignores
¡ You just graduated
¡ You interviewed with your
dream company
¡ Great news: They make
you an offer!
¡ Now let’s discuss $$
Marks: Well, Sally, we were all very impressed with you and would
like to offer you a starting salary of $50,000. In addition, you will
also receive a signing bonus.

Jameson: The base salary is a little below what I had expected. Is that
negotiable?

Marks: I’m afraid not. That’s the same starting package all MBAs get.
However, you will receive a bonus upon accepting our offer. You
can receive $5,000 in cash, or choose stock options instead.
¡ Call options issued by a firm on its own stock

¡ Typically: American at-the-money call

options

¡ Often: Maturity as long as 10 years

¡ Vesting period
§ Period before which the options cannot be
exercised
§ You leave during the vesting period? Options are
forfeited
§ You leave after the vesting period? In-the-money
options are exercised immediately; out-of-the-
money options are forfeited
¡ Employees not permitted to sell the options
¡ When the options are exercised, the firm
issues new shares/ buys on the market
already existing shares/ settles the options in
cash
¡ To realize cash from an employee stock
option, employee must
i. Exercise the option
ii. Sell the underlying shares
#1 Options to executives
¡ Pre-1992: Executive compensation
deductible
¡ Post-1992: Beyond a threshold level,
executive compensation deductible only if
incentive-based
⇒ Options become more popular
#2 Options to all employees
¡ Pre-1995: Cost of ESO on income statement
= intrinsic value on issue date
§ ATM call, on issuance date = ?
¡ Post-1995: Fair value must be reported in the
notes (not needed on income statement)
¡ Post-2005: FASB and IASB require fair value
in income statement
¡ Until accounting rules changed, traditional
ATM call option plans made sense
¡ More recent alternatives
§ Strike linked to stock index: have to beat the
index to move in the money
§ Strike price increasing in a predetermined way
§ Options vest only if specified profit targets are
met
¡ 3,000 options
¡ Option parameters:
§ 𝐾 = $35.00
§ 𝑇 = 5 years
§ 𝑟 = 6.02%
¡ Current stock price: 𝑆! = $18.75
¡ Should SJ take the cash bonus, or the option
grant?
¡ Optimal exercise policy of American call
options?
¡ However, they tend to be exercised early
¡ Value as a European option, with maturity
equal to “expected life”
§ No theoretical justification; but reasonable results

§ In our case: Use 5 years as benchmark

¡ European call price formula:
𝑐 = 𝑆! 𝑁 𝑑" − 𝐾𝑒 #$% 𝑁 𝑑&

'( )/+, $,- ! /& %

𝑑" = ; 𝑑& = 𝑑" − 𝜎 𝑇
- %

¡ Missing information?
¡ Where do we find 𝜎?
A. Historical data
 Telstar stock
price, 1982-1992

Source: Case Exhibit 2

Telstar volatility, 1987 crash
1982-1992

Average historical 𝜎 ≈ 37%

Source: Case Exhibit 3

¡ Where do we find 𝜎?
A. Historical data

B. Implied volatilities
¡ Can obtain implied estimates of 𝜎 from
quoted option prices
¡ How do we obtain them?

Call option prices quoted Maturity

on the market K 1m 2m 5m 19m
$12.5 $7.75
$17.5 $1.43 $1.88 $2.50 $4.63
$20.0 $0.19 $0.50 $1.31 $3.75
$22.5 $0.13 $0.56
Source: Case Exhibit 1
 Maturity
Implied
K 1m 2m 5m 19m
volatilities 𝜎 $12.5 39%
$17.5 27% 36% 35% 37%
Average: $20.0 27% 31% 35% 39%
34% $22.5 33% 34%

Option prices quoted on Maturity

the market K 1m 2m 5m 19m
$12.5 $7.75
$17.5 $1.43 $1.88 $2.50 $4.63
$20.0 $0.19 $0.50 $1.31 $3.75
$22.5 $0.13 $0.56
Source: Case Exhibit 1
¡ Where do we find 𝜎?
A. Historical data

B. Implied volatilities

¡ Pros and cons of either approach?

¡ Why use a range of values?
 B-S call Grant
Volatility
value value
20% $1.34 $ 4,007
24% $1.95 $ 5,849
28% $2.60 $ 7,785
32% $3.26 $ 9,769
36% $3.92 $11,774
40% $4.59 $13,778

¡ Cash bonus or option grant?

¡ How does SJ’s option grant differ from Black-
Scholes “textbook” conditions?

§ Vesting

§ Taxes

§ Illiquidity
¡ If SJ leaves before 5 years, her options are
worthless
¡ Probability 𝜋 of leaving Telstar early affects
the value of the option grant
¡ Suppose 𝜎 = 34%; what value of 𝜋 makes SJ
prefer the cash bonus?
$10,770× 1 − 𝜋 + $0×𝜋 = $5,000
 B-S call Grant Leaving
Volatility
value value prob. 𝝅
20% $1.34 $ 4,007 0%
24% $1.95 $ 5,849 15%
28% $2.60 $ 7,785 36%
32% $3.26 $ 9,769 49%
36% $3.92 $11,774 58%
40% $4.59 $13,778 64%

¡ Cash bonus or option grant?

¡ What 𝜋 makes cash bonus more attractive?
¡ How does SJ’s option grant differ from Black-
Scholes “textbook” conditions?

§ Vesting

§ Taxes

§ Illiquidity
¡ SJ’s marginal tax rate is 28%, so the cash
bonus is worth to her $3,600

¡ What tax does SJ pay today if she takes the

option grant?

¡ What is the PV of her deferred taxes?

¡ Suppose 𝜏 = 28% as of today

¡ Tax liability = Option value ×28%

¡ Suppose 𝜎 = 34%; what value of 𝜏 makes SJ

prefer the cash bonus?
$11,272× 1 − 𝜏 = $3,600
 B-S call Grant Leaving Tax rate
Volatility
value value prob. 𝝅
20% $1.34 $ 4,007 0% 10%
24% $1.95 $ 5,849 15% 38%
28% $2.60 $ 7,785 36% 54%
32% $3.26 $ 9,769 49% 63%
36% $3.92 $11,774 58% 69%
40% $4.59 $13,778 64% 74%

¡ Cash bonus or option grant?

¡ What 𝜋 makes cash bonus more attractive?
¡ What 𝜏 makes cash bonus more attractive?
¡ How does SJ’s option grant differ from Black-
Scholes “textbook” conditions?

§ Vesting

§ Taxes

§ Illiquidity
¡ SJ cannot trade her options

¡ A bank wouldn’t lend to her against the

option grant

¡ SJ’s human capital very invested in Telstar;

inability to diversify financial capital – what
does her portfolio look like?
¡ Employee stock options are costly for
shareholders

¡ Main cost: Dilution

§ New shares are issued

§ And they are bought at below-market price

¡ Firm has 𝑁 shares, with price 𝑆!
¡ It announces issue of 𝑀 employee stock
options – impact on the stock price?
¡ Suppose without ESO, price would be 𝑆% at
maturity ⇒ value 𝑁𝑆%
¡ If ESO exercised, cash flow 𝑀𝐾
¡ 𝑁𝑆% value + 𝑀𝐾 ESO cash flow, distributed
among 𝑁 + 𝑀 shares:
𝑁𝑆% + 𝑀𝐾
New price =
𝑁+𝑀
¡ Payoff to option holder:
𝑁𝑆% + 𝑀𝐾 𝑁
−𝐾 = 𝑆% − 𝐾
𝑁+𝑀 𝑁+𝑀
Value of
“regular” call
¡ Total cost of the ESO plan:
𝑁
𝑀× ×Call
𝑁+𝑀

¡ New firm value = Old value – Cost of ESO plan

¡ Your firm has 1m shares with 𝑆! = $40. It
considers issuing 200,000 ESO with strike
price $60 and expected life 5 years; 𝑟 = 3%,
𝜎 = 30%, and the firm pays no dividends.
What is the impact on the stock price?
¡ Your firm has 1m shares with 𝑆! = $40. It
considers issuing 200,000 ESO with strike
price $60 and expected life 5 years; 𝑟 = 3%,
𝜎 = 30%, and the firm pays no dividends.
What is the impact on the stock price?
𝑐 = 𝑆! 𝑁 𝑑" − 𝐾𝑒 #$% 𝑁 𝑑& = $7.04
¡ Your firm has 1m shares with 𝑆! = $40. It
considers issuing 200,000 ESO with strike
price $60 and expected life 5 years; 𝑟 = 3%,
𝜎 = 30%, and the firm pays no dividends.
What is the impact on the stock price?
. ",!!!,!!!
= = 0.83
.,/ ",!!!,!!!,&!!,!!!
¡ Your firm has 1m shares with 𝑆! = $40. It
considers issuing 200,000 ESO with strike
price $60 and expected life 5 years; 𝑟 = 3%,
𝜎 = 30%, and the firm pays no dividends.
What is the impact on the stock price?
ESO price = 0.83×$7.04 = $5.87
ESO value = 200,000×$5.87 = $1.17 million
¡ Your firm has 1m shares with 𝑆! = $40. It
considers issuing 200,000 ESO with strike
price $60 and expected life 5 years; 𝑟 = 3%,
𝜎 = 30%, and the firm pays no dividends.
What is the impact on the stock price?
New value = $40×1m − $1.17m = $38.83m
New stock price = $𝟑𝟖. 𝟖𝟑
Dilution = 2.9%
¡ Employee stock options are costly for
shareholders

¡ Why do we use them? Incentives

¡ But: do they work?

¡ “Pay for luck”: typically do well when stock
market as a whole goes up, even if your firm
underperforms it
¡ Can encourage focus on short-term
performance (at expense of long-term)
¡ “Spring-loading”: tempt executives to time
corporate announcements to maximize
option value
 Abnormal stock returns around executive stock option grants

Read more at: https://www.biz.uiowa.edu/faculty/elie/backdating.htm

$ ¡ Options may
Safe strategy
induce
Risky strategy managers to
undertake “too
much” risk
Option ¡ Another way to
see it:
𝜕𝐶
𝜈= >0
𝜕𝜎

P K Stock price
Source: Conyon, M. J., N. Fernandes, M. Ferreira, P. Matos, and K. J. Murphy, 2011, The Executive Compensation
Controversy: A Transatlantic Analysis, Working Paper, University of Southern California