Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 16: Employee Stock Options

Multiple Choice Test Bank: Questions with Answers

1. Which of the following is true?

A. An employee stock option is usually held to maturity
B. An employee stock option tends to be exercised earlier than a traded option with the
same terms
C. An employee stock options tends to be exercised later than a traded option with the
same terms
D. Employee stock options are usually exercised as early as possible

Answer: B

Employee stock options tend to be exercised earlier than similar traded options. This is
because they cannot be sold and exercising them is the only way to monetize gains. A, C, and
D are not true.

2. Which of the following is NOT usually true about employee stock options?
A. There is a vesting period
B. They can be sold to other employees
C. They are often at-the-money when issued
D. Their value is currently a charge to the income statement

Answer: B

Employee stock options cannot be sold. A, C, and D are true.

3. What term is used to describe losses shareholders experience because the interests of managers
are not aligned with their own?
A. Agency costs
B. Backdating scandals
C. Dilution
D. Income statement expense

Answer: A

“Agency costs” refers to costs arising because the interests of managers and shareholders
are not aligned.

4. Which of the following are true of employee stock options?

A. They are commonly valued as though they are regular American options
B. They are commonly valued as though they are regular American options, but with a reduced
life.
C. They are commonly valued as though they are regular European option
D. They are commonly valued as though they are regular European options but with a reduced
life.
 Answer: D

They are commonly valued using Black-Scholes-Merton (i.e. as European options) but with
a reduced life to reflect early exercise behavior

5. Which of the following was true about employee stock options prior to 1995?
A. The options never had any affect on a company’s financial statements
B. The value of options which were at-the-money when issued had to be expensed on the
income statement
C. The value of options which were at-the-money when issued had to be reported in the
notes to the financial statements
D. Options which were at-the-money when issued did not affect a company’s financial
statements

Answer: D

Options which were at the money were assumed to have no cost to a company prior to
1995.

6. Which of the following was true about employee stock options between 1996 and 2004?
A. The options never had any affect on a company’s financial statements
B. The value of options which were at-the-money when issued had to be expensed on the
income statement
C. The value of options which were at-the-money when issued had to be reported in the
notes to the financial statements
D. Options which were at-the-money when issued did not affect a company’s financial
statements

Answer: C

The value of options had to be reported in the notes to the financial statements between
1996 and 2004. They did not have to be expensed.

7. Which of the following was true after 2005?

A. The options never had any affect on a company’s financial statements
B. The value of options which were at-the-money when issued had to be expensed on the
income statement
C. The value of options which were at-the-money when issued had to be reported in the
notes to the financial statements
D. Options which were at-the-money when issued did not affect a company’s financial
statements

Answer: B

After 2005 options had to be expensed on the income statement.

8. Which of the following is true about employee stock options after they have been issued?
A. They have to be revalued every year
B. They have to be revalued every quarter
C. They have to be revalued every day like other derivatives
D. They never have to be revalued

Answer: D

Options are valued when issued but do not have to be valued subsequently.

9. Which of the following is true about the practice of backdating a stock options grant?
A. It is illegal
B. It is illegal in the majority of states in the U.S., but not all states
C. It is illegal in roughly half the states in the U.S.
D. It is unethical, but not illegal

Answer: A

Backdating is illegal

10. A company surprises the market with an announcement that it has granted stock options to
senior executives. The options are exercised four years later. When does dilution take place?
A. Dilution takes place when the options are exercised
B. Dilution takes place on the announcement date
C. Dilution takes place gradually over the four years
D. There is no dilution

Answer: B

Efficient markets should ensure that dilution takes place at the time of the announcement.

11. When an employee leaves the company which of the following is usually true?
A. All outstanding employee stock options are forfeited
B. Out-of the money employee stock options are forfeited
C. All options which have vested are forfeited
D. All options are retained

Answer: B

Usually out-of-the-money options are forfeited and in-the-money options have to be

exercised immediately.

12. Which of the following defines the vesting period?

A. The period during which employee stock options can be exercised
B. The period during which the options are issued
C. The period during which the strike price of the options equals the stock price
D. The period during which employee stock options cannot be exercised
 Answer: D

The vesting period is the period during which options cannot be exercised.

13. Which of the following is NOT true?

A. Management has an incentive to issue executive stock options after bad news
B. Management has an incentive to issue executive stock options before good news
C. Executive stock options encourage management to pursue strategies that are best for
the company in the long run
D. Management have an incentive to time the announcement of good news just before
they plan to exercise their stock options

Answer: C

Executive stock options tend to cause management to have short-term horizons. A, B, and D
are not true. This is because management want to issue options when the price is low and
exercise when the price is high.

14. Which of the following strategies makes no sense?

A. An employee exercises stock options early and sells the stock. No dividends are expected
B. An employee exercises stock options early and keeps the stock. No dividends are
expected
C. An employee exercises stock options early and sells the stock. Dividends are expected
D. An employee exercises stock options early and keeps the stock. Dividends are expected.

Answer: B

An exchange-traded call option on a non-dividend-paying stock should never be exercised

early. The only reason for exercising an employee stock option is monetize it. (The option
cannot be sold). But to monetize the option the shares of stock that are obtained must be
sold.

15. When a CEO has employee stock options, he or she is in theory motivated to do which of the
following?
A. Take more risk
B. Take less risk
C. Buy some of the company’s stock
D. None of the above

Answer: A

If the CEO takes more risk, volatility increases and the options become more valuable.

16. When an employee stock option is exercised, which of the following is usually true?
A. The employee pays the market price for the shares and the company refunds the
difference between the market price and the strike price
B. The company or the company’s agent buys stock in the market for the employee
 C. The company issues more shares and sells them to the employee for the strike price
D. The employee cannot immediately sell the shares

Answer: C

When an option is exercised the company issues more shares and sells them to the
employee for the strike price.

17. Which of the following increases the expected life of employee stock options?
A. An increase in the vesting period
B. An increase in employee turnover
C. A fast growth rate for the stock price
D. A tendency for employees to exercise earlier than in the past

Answer: A

If the vesting period increases employees must wait longer before they are allowed to
exercise.

18. Which of the following hypotheses was supported by empirical research covering the 1995 to
2002 period?
A. The grant date for executive stock options tended to be when the stock price is high
B. The grant date for executive stock options tended to be when the stock price is low
C. The grant date for executive stock options tended to be after a growth spurt in the stock
price
D. The was no relationship between the timing of grants and the stock price

Answer: B

Empirical research showed that the grant date was a low point for the stock price. This was
used as evidence for backdating.

19. Which of the following ensures that managers are rewarded only when a company performs
better than its competitors?
A. A constant strike price for executive stock options
B. A strike price that increases with time
C. A strike price that changes in line with an index of stock prices
D. A strike price that is tied to reported profit

Answer: C

If an option is initially at the money and the strike price increases in line with an index, the
company must outperform the index for the option to move in the money

20. Employee stock options are particularly popular with start ups because
A. They encourage employees to work hard
B. The start up cannot afford to pay high salaries
C. The risk associated with the company’s success is shared with employees.
D. All of the above

Answer: D

A, B, and C are all reasons why employee stock options are attractive to a start up