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    D l7 Esos

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    This document discusses employee stock options. It describes employee stock options as call options issued by a company on its own stock that are often at-the-money at the time of issue. It notes they typically have vesting periods, and exercised options result in the company issuing new shares. Prior to 2005, accounting rules did not always require expensing the fair value of options. The document also discusses potential drawbacks of stock options, valuation methods, dilution, and the uncovered practice of backdating option grant dates.

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    D l7 Esos

    Uploaded by

    anashj2
    25 views12 pages
    This document discusses employee stock options. It describes employee stock options as call options issued by a company on its own stock that are often at-the-money at the time of issue. It notes they typically have vesting periods, and exercised options result in the company issuing new shares. Prior to 2005, accounting rules did not always require expensing the fair value of options. The document also discusses potential drawbacks of stock options, valuation methods, dilution, and the uncovered practice of backdating option grant dates.

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    Derivatives

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    d-l7-esos

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    This document discusses employee stock options. It describes employee stock options as call options issued by a company on its own stock that are often at-the-money at the time of issue. It notes they typically have vesting periods, and exercised options result in the company issuing new shares. Prior to 2005, accounting rules did not always require expensing the fair value of options. The document also discusses potential drawbacks of stock options, valuation methods, dilution, and the uncovered practice of backdating option grant dates.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    25 views12 pages

    D l7 Esos

    Uploaded by

    anashj2
    This document discusses employee stock options. It describes employee stock options as call options issued by a company on its own stock that are often at-the-money at the time of issue. It notes they typically have vesting periods, and exercised options result in the company issuing new shares. Prior to 2005, accounting rules did not always require expensing the fair value of options. The document also discusses potential drawbacks of stock options, valuation methods, dilution, and the uncovered practice of backdating option grant dates.

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    MBF1243 Derivatives

    L7: Employee Stock Options

    Nature of Employee Stock Options


    Employee stock options are call options issued by
    a company on its own stock
    They are often at-the-money at the time of issue
    They often last as long as 10 years

    Typical Features of Employee Stock Options


    There is a vesting period during which options cannot
    be exercised
    When employees leave during the vesting period
    options are forfeited
    When employees leave after the vesting period in-themoney options are exercised immediately and out of the
    money options are forfeited
    Employees are not permitted to sell options
    When options are exercised the company issues new
    shares
    3

    Exercise Decision
    To realize cash from an employee stock option the
    employee must exercise the options and sell the
    underlying shares
    Even when the underlying stock pays no dividend an
    employee stock option (unlike a regular call option) is
    often exercised early

    Drawbacks of Employee Stock Options


    Gain to executives from good performance is much
    greater than the penalty for bad performance
    Executives do very well when the stock market as a
    whole goes up, even if their firm does relatively poorly
    Executives are encouraged to focus on short-term
    performance at the expense of long-term performance
    Executives are tempted to time announcements or take
    other decisions that maximize the value of the options
    5

    Accounting for Employee Stock Options


    Prior to 1995 the cost of an employee stock option on
    the income statement was its intrinsic value on the issue
    date
    After 1995 a fair value had to be reported in the notes
    (but expensing fair value on the income statement was
    optional)
    Since 2005 both FASB and IASB have required the fair
    value of options to be charged against income at the
    time of issue
    6

    Traditional At-the-Money Call Options


    The attraction of at-the-money call options used to be
    that they led to no expense on the income statement
    because they had zero intrinsic value on the exercise
    date
    Other plans were liable to lead an expense
    Now that the accounting rules have changed some
    companies are considering other types of plans

    Nontraditional Plans page 358


    Strike price is linked to stock index so that the
    companys stock price has to outperform the
    index for options to move in the money
    Strike price increases in a predetermined way
    Options vest only if specified profit targets are
    met

    Valuation of Employee Stock Options


    Most common approach is to use Black-ScholesMerton with time to maturity equal to an estimate of
    expected life
    There is no theoretical justification for this but it seems
    to give reasonable results in most circumstances

    Dilution
    Employee stock options are liable to dilute
    the interests of shareholders because new
    shares are bought at below market price
    However this dilution takes place at the time
    the market hears that the options have been
    granted (Business Snapshot 15.3)
    It does not take place at the time the options
    are exercised

    10

    Backdating
    Backdating appears to have been a widespread
    practice in the United States
    A company might take the decision to issue at-themoney options on April 30 when the stock price is
    $50 and then backdate the grant date to April 3 when
    the stock price is $42
    Why would they do this?

    11

    Academic Research Exposed Backdating (See Eric


    Lies web site: www.biz.uiowa.edu/faculty/elie/backdating.htm

    12

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