Stock Options Term Paper

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Stock Options

Payment of stratospheric compensations to the corporate executives by the companies is the talk of the day. It is pertinent to note that these compensations are paid not only in terms of the cash compensations but also in terms of stock options. However, compensations plans in terms of stock options are not new and being used years together in order to attract the employees and retain with a bondage to the company. The rationale is to give the ownership interest in the company with an expectation that the executive will improve their performances working closely with the share holder interests and the company's long-term profit maximization goals. The stock options as a part of the package for compensating the executives has much more wide spread presently with the cropping up of Internet-based companies.

The origin of the stock options perhaps traced back to the efforts of the start up companies who being cash poor preferred to pay the executives in terms of stock options as part of their compensation package as they could not afford to pay them competitive salaries. Presently it has become the trend with the success of a handful of dot com companies. The stock options are presently attractive even to the traditional employees for its wealth building potential. Being allured by the success of their counterparts in dot com companies being millionaires overnight, the executives of traditional companies are more anxious to exploit the opportunities. Against this background it is predicted that the continuous boom in stock markets make the stock options to be viewed as a lucrative part of the compensation package. [Among CEOs throughout Corporate America and It's changing The Way Many of Them Are Paid]

Stock Options are a form of contract that confers the right on the executives to purchase a share of stock at a pre-determined 'exercise' price for a pre-determined period. The option revolves around many terminologies such as listed stock, an exchange index, futures contracts, real estate etc. The listed stocks are conveniently grouped as American and European. The American style of option contract allows flexibility for exercising the option contract at any moment of time from the date of purchase to the date of expiration. All the stock options are grouped as American style. Conversely the European style option refers to the option contract that can only be exercised on the date of expiration. The Future Contracts are grouped under the European style of options.

It is customary to designate each and every stock option by the name of the stock associated, the strike price, the expiration date, the payment of premium for the option and also the commission for brokerage. Call and Puts are said to be the most widely discussed options. Owning a call confers one with the rights but not obligations to buy the stocks at the exercised price only before the expiry of the option. And the option has no value once it expires. The writing options allow people to sell options without even having owned them before. When a call is written it is an obligation to sell shares at the pre-specified price at any moment before expiry of the date when called upon. Writing a call option after actually owning the stock refers to Covered Call Writing and conversely, writing without owning the stock is known as Naked Call Writing. Owning a Put confers right to sell a stock at any moment of time before expiry of the option. Writing a put makes it obligatory to buy shares at the strike price at any moment before actual expiry, when assigned. [Stock Options - What is it?]

The stock options have become an important part of executive compensation. Over the past decades most significant changes have been viewed in the sphere of corporate compensation practices in terms of escalations and declines in executive and employee stock options. It has been rightly said that even if the importance of the stock options are growing day by day perhaps this is the reason for it become increasingly controversial. The philosophy behind the stock options is offering of a direct link between the realized compensation and company stock price performance in order to imbibe the executives and employees greater incentive for working in the interests of shareholders. Moreover, the intention behind offering of stock options instead of cash compensation is to attract the highly motivated and entrepreneurial employees and also enable the companies utilizing the services without actually incurring cash expenditure. [The Trouble with Stock Options]

The stock options are so engineered that the executives can only benefit most out of them only with attaching themselves to the firm thus providing an incentive for retention. Besides the stock options also acts as a form of encouragement for executive risk taking. The stock option involves issue of new share by the companies with exercise of option by the employees resulting in the number of outstanding shares. In most of the instances the company offers 'cashless exercise programs' which requires the employee to pay nothing and to receive the value of difference between the market price and the exercise price in cash or in terms of stocks. The gap between the cost and value of stock options are wider, the cost of granting stock options being greater than that of the value that the employee receives. [The Trouble with Stock Options]

The cost calculated in terms of the opportunity cost of the option to the firm is conceived in terms of the amount that the company would have to pay an outside investor in lieu of acceptance of the financial liability of the stock options granted to the executives. Similarly the cost of options equals to the amount that an outside investor pays for the option with assumption of the same exercise and forfeiture patterns of company employees. It is seen that with reasonable assumptions with regards to risk aversion and diversification the value options granted with an exercise price equaling to the market price the employees value the stock options only at about half of their cost to the firm. The value-cost ratio is said to be smaller considerably with options having exercise prices higher than existing market price.

This is also possible when the exercise prices increased over a period of time and when options have a long vesting period. In this way the efficacy of the stock options as a method of providing compensation depends upon the adequacy of the benefits of attraction, retention and motivational forces influencing the employees for justifying the compensating differentials between the cost and value of the stock options. One of the most important potential benefits that the firm expects out of providing compensation in the form of options is the attraction of employees without actually incurring cash expenditure. This benefit actually needs evaluation in terms of the compensating deferential demanded by the option holding employees. With the grant of the stock options the companies defer payments of cash actually involving a borrowing from employees in terms of services in exchange of volatile payouts in future. [The Trouble with Stock Options]

Such compensations in lieu of cash is said to affect the type of employees that the company can attract. Such offerings of stock option will attract only those employees who are highly motivated and entrepreneurial and who have enough confidence on themselves for increasing the stock prices of the company. The justification of this benefit in compensating the differential charged by the employees for accepting risky compensation mostly depends on the availability of the other managerial characteristics. However, it is open to realize that the philosophy attraction behind stock option is mostly confined only to the top managers and some key engineers or technical employees having confident of directly influencing the stock prices.

This portion of the employees only constitutes a small fraction of the holders of the total grant of stock options. A major chunk of the stock option holders in the company are from lower level positions. These stock options can attract only that portion of the total at this level of employees who are relatively less risk averse. The objective of attracting less risk averse employees can better be fulfilled by means of offering bonus plans tying to performance measures which provides both sorting and incentive while the stock options only provides sorting but not incentive at this level. Thus justifying the objective of attraction is not fruitful in case of stock options. It can attract only a top managerial class but fails to provide incentive to the lower level of employees. [The Trouble with Stock Options]

Another objective of stock options is to ensure Retention incentive of course putting restrictions with provisions for forfeiture of the unvested stock options with the leaving of the employee. Such incentive for retention by the stock options is said to be highest only when the exercise price of the options are sufficiently above the exercise price in order to induce the employee to remain in…

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