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HullFund8eCh14ProblemSolutions

HullFund8eCh14ProblemSolutions
HullFund8eCh14ProblemSolutions

CHAPTER 14

Employee Stock Options

Practice Questions

Problem 14.8.

Explain how you would do the analysis to produce a chart such as the one in Figure 14.1.

It would be necessary to look at returns on each stock in the sample (possibly adjusted for the returns on the market and the beta of the stock) around the reported employee stock option grant date. One could designate Day 0 as the grant date and look at returns on each stock each day from Day –30 to Day +30. The returns would then be averaged across the stocks.

Problem 14.9.

On May 31 a company’s stock price is $70. One million shares are outstanding. An executive exercises 100,000 stock options with a strike price of $50. What is the impact of this on the stock price?

There should be no impact on the stock price because the stock price will already reflect the dilution expected from the executive’s exercise decision.

Problem 14.10.

The notes accompanying a company’s financial statements say: “Our executive stock options last 10 years and vest after four years. We valued the options granted this year using the Black –Scholes –Merton model with an expected life of 5 years and a volatility of 20%. ”What does this mean? Discuss the modeling approach used by the company.

The notes indicate that the Black-Scholes-Merton model was used to produce the valuation with the option life being set equal to 5 years and the stock price volatility being set equal to 20%.

Problem 14.11.

A company has granted 500,000 options to its executives. The stock price and strike price are both $40. The options last for 12 years and vest after four years. The company decides to value the options using an expected life of five years and a volatility of 30% per annum. The company pays no dividends and the risk-free rate is 4%. What will the company report as an expense for the options on its income statement?

The options are valued using Black-Scholes-Merton with 040S =, 40K =, 5T =, 03=.σ and 004r =.. The value of each option is $13.585. The total expense reported is

50000013585$,?. or $6.792 million.

Problem 14.12.

A company’s CFO says: “The accounting treatment of stock options is crazy. We granted 10,000,000 at-the-money stock options to our employees last year when the stock price was $30. We estimated the value of each option on the grant date to be $5. At our year end the

stock price had fallen to $4, but we were still stuck with a $50 million charge to the P&L.” Discuss.

The problem is that under the current rules the options are valued only once —on the grant date. Arguably it would make sense to treat the options in the same way as other derivatives entered into by the company and revalue them on each reporting date. However, this does not happen under the current rules in the United States unless the options are settled in cash.

Further Questions

Problem 14.13

A company has granted 2,000,000 options to its employees. The stock price and strike price are both $60. The options last for 8 years and vest after two years. The company decides to value the options using an expected life of six years and a volatility of 22% per annum. The dividend on the stock is $1, payable half way through each year, and the risk-free rate is 5%. What will the company report as an expense for the options on its income statement?

The options are valued using Black--Scholes with K =60, T =6, σ =0.22, r =0.05. The present value of the dividends during the six years assumed life are

1×e -0.05×0.5+1×e -0.05×1.5+1×e -0.05×2.5+1×e -0.05×3.5+1×e -0.05×4.5+1×e -0.05×5.5 = 5.183

The stock price, S 0, adju sted for dividend is therefore 60 ?5.183=54.817. The Black--Scholes model gives the price of one option as $16.492. The company will therefore report as an expense 2,000,000×5.183 or $32.984 million.

Problem 14.14.

(a) Hedge funds earn a management fee plus an incentive fee that is a percentage of the profits (after fees and expenses), if any, that they generate (see Business Snapshot 1.3). How is a fund manager motivated to behave with this type of compensation package? (b) "Granting options to an executive gives the executive the same type of compensation package as a hedge fund manager and motivates him or her to behave in the same way as a hedge fund manager" Discuss this statement.

(a) Suppose that K is the value of the fund at the beginning of the year and T S is the net value of the fund at the end of the year (after fees and expenses). In addition to the management fee the hedge fund earns

max(0)T S K -,α

where α is a constant.

This shows that a hedge fund manager has a call option on the net value of the fund at the end of the year. One parameter determining the value of the call option is the

volatility of the fund. The fund manager has an incentive to make the fund as volatile as possible! This may not correspond with the desires of the investors. One way of making the fund highly volatile would be by investing only in high-beta stocks.

Another would be by using the whole fund to buy call options on a market index. Amaranth provides an example of a hedge fund that took large speculative positions to maximize the value of its call options.

It is interesting to note that the managers of the fund could personally take positions that are opposite to those taken by the fund to ensure a profit in all circumstances (although there is no evidence that they do this).

(b)An executive who has a salary plus options has a remuneration package similar to that

of the hedge fund. The hedge fund’s management fee corresponds to the executive’s salary and the hedge fund’s investments correspo nd to the stock on which the

executive has options. In theory, granting the executive options encourages him/her to take risks so that volatility is increased in the same way that the hedge fund’s

remuneration package encourages it to take risks. However, while examples such as Amaranth show that some hedge fund managers do take risks to increase the value of their option, it is less clear that executives behave similarly.

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