Question

Managerial compensation packages often include stock options with the goal of aligning managers’ incentives with those of the shareholders. These call options give the manager the right, but not the obligation to purchase shares at the strike price on or before a certain maturity date. Discuss two different possible complications that might arise with certain options (think about option’s maturity and the “moneyness” of the option).

Answer 1

Most often it happens in the corporate world, that the interests of executives and shareholders diverge when executives maximize their own utility rather than shareholders’ wealth. Without proper incentives, executives generally prefer to consume perquisites and undertake less risk than what optimizes firm value.Jensen and Meckling (1976) first talked about this phenomenon. Jensen and Meckling suggest that one solution to reduce the divergence of interests is to establish incentive compensation systems for the manager or to give him stock options which mitigates managerial risk aversion and induces greater risk-taking behavior on the part of the managers.

Employee stock options (ESOs) are a type of equity compensation granted by companies to their employees and executives.Instead of granting shares of stock directly, the company gives derivative options on the stock. These options come in the form of regular call options and give the employee the right to buy the company's stock at a specified price for a finite period of time. Terms of ESOs are fully spelled out for an employee in an employee stock options agreement.

In general, the greatest benefits of a stock option are realized if a company's stock rises above the exercise price. Typically, ESOs are issued by the company and cannot be sold, unlike standard listed or exchange-traded options. When a stock’s price rises above the call option exercise price, call options are exercised and the holder obtains the company’s stock at a discount. The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time.

Stock options can also serve as an incentive for employees to stay with the company. The options are canceled if the employee leaves the company before they vest. ESOs do not include any dividend or voting rights.

ESOPS are of two main types:

1. Incentive stock options (ISOs), also known as statutory or qualified options, are generally only offered to key employees and top management. They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.
2. Non-qualified stock options (NSOs) can be granted to employees at all levels of a company, as well as to board members and consultants. Profits on these are considered as ordinary income and are taxed as such.

Two Complications of ESOs regarding "maturity" & the "moneyness"

The ESOPS generally come with certain restrictions, most important of which is the vesting period. The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs. This restriction is because the ESOs gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.

ESOs are considered vested when the employee is allowed to exercise the options and purchase the company’s stock. However, the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to have the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company.
ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule. For example, the employee may be granted the right to buy 1,000 shares, with the options vesting 25% per year over four years with a term of 10 years. So 25% of the ESOs, conferring the right to buy 250 shares would vest in one year from the option grant date, another 25% would vest two years from the grant date, and so on. However after 10 years, the employee would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the 10-year period (counting from the date of the option grant) is up.

The value of an option consists of intrinsic value and time value.

Time value depends on the amount of time remaining until expiration (the date when the ESOs expire) and several other variables. Given that most ESOs have a stated expiration date of up to 10 years, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.

To calculate the time value for ESOs, the employee would have to use a theoretical pricing model like Black-Scholes option pricing model to compute the "fair value" of ESOs. Some inputs are to be given such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.

Intrinsic Value- The intrinsic value is the difference between the current market price of the stock and the exercise /strike price. For example, if Microsoft's current market price is $50 and the option's strike price is $40, the intrinsic value is $10.
Intrinsic value, which can never be negative, is zero when an option is “at the money” (ATM) or “out of the money” (OTM). Hence for these options, their entire value consists only of time value.

The exercise of an ESO will capture intrinsic value but usually gives up time value, resulting in a potentially large hidden opportunity cost.Lets assume that the calculated fair value of an ESOs is $40. Subtracting intrinsic value of $30 gives the ESOs a time value of $10. If the manager exercises his ESOs in this situation, he would be giving up time value of $10 per share, or a total of $2,500 based on 250 shares.

The value of ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and volatility.
A situation where the ESOs are out of the money (i.e., the market price of the stock is now below the ESOs exercise price), it would be illogical to exercise the ESOs since it is cheaper to buy the stock in the open market at $20, as compared with the exercise price of the ESO at $25.

Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio. However the value of ESOs is'nt easy to ascertain, because there is no market price reference point. Option prices can vary widely, depending on the assumptions made in the input variables. For example, if the employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices. If the company assumes lower than normal levels of volatility, the ESOs would be priced lower.

When the ESOs are received at the time of grant, they typically have no intrinsic value because the ESO strike price or exercise price is equal to the stock’s closing price on that day. Once the stock begins to rise, the option has intrinsic value. But a common mistake with the ESOs is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise. The greater the time to expiration, the more the ESO is worth. Since we assume this is an at-the-money option, its entire value consists of time value.
The value of options declines as the expiration date approaches, a phenomenon known as time decay, but this time decay is not linear in nature and accelerates close to option expiry. An option that is far out-of-the-money will decay faster than an option that is at the money, because the probability of the former being profitable is much lower than that of the latter.

Also as a way to reduce risk and lock in gains, early or premature exercise of ESOs must be carefully considered, since there is a large potential tax disadvatage and big opportunity cost in the form of forfeited time value. Even if the manager begins to gain intrinsic value as the price of the underlying stock rises, he will be shedding time value along the way (although not proportionately). For example, for an in-the-money ESO with a $50 exercise price and a stock price of $75, there will be less time value and more intrinsic value. The further "out of the money" that an option is, the less time value it has, because the chance of it becoming profitable are increasingly less. As an option gets more "in the money" and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for a deeply "in-the-money" option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many ESO holders look to lock in all or part of the gain, but in doing so, they give up time value as well as incur a hefty tax bill in form capital gain tax. The manager can be taxed at ordinary income tax rates on the ESO intrinsic value gain, at rates as high as 40%.