New performance-vested stock option schemes

Markus Pelger
University of California, Berkeley
joint with An Chen (Bonn) and Klaus Sandmann (Bonn)
Midwest Finance Association 2011 Conference
Chicago
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Executives stock options
Motivation
Executives stock options were introduced
to provide managers remuneration
to provide managers incentives to increase the rms value
(more eort, right risk decisions)
Ongoing discussion: ESOs can encourage the managers to
take on too large risks
Empirical evidence (Hambrick et. al): Higher fraction of ESOs
of total salary coincides with higher variance of the rms stock
Existing options can be easily manipulated by the executives
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
ESOs
Exaggerated Risk-Taking
Dierent proposals to prevent managers from exaggerated risk
taking:
The bonuses shall be coupled with a reference index (instead
of the rms stock)
Reducing the fraction of the executives payment in stock
options
ESOs shall be linked to some performance hurdle
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
This paper
Contribution
1
Valuation of new performance-vested stock options
Parisian executives stock options
The stock price should have outperformed a certain stock price
which is xed at the granting date for a xed length of time d
Asian executives stock option plans
Under an Asian scheme, the executives compensation is
coupled with the average performance of the stock price.
Constrained Asian scheme: additionally require the total
return shall lie above a reference level
2
Question: Do the new ESO really prevent the managers from
pursuing too risky risk management strategies?
Choose portfolios of the dierent ESOs with the same price
and examine how the portfolio value changes when the
manager invest in a more risky (higher volatility) strategy
A new risk measure to study the risk sensitivity of the ESOs.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
This paper
Not included features
In our analysis, we ignore the following features incorporated in
ESOs:
early-exercise feature (Bettis et. al. (2005) and Sircar and
Xiong (2007))
non-tradable restriction (Carpenter (2000))
reloading or resetting feature (see e.g. Dybvig and
Loewenstein (2003))
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Agenda
1
Introduction (

)
2
Contract specication
3
Valuation
4
Comparing the dierent ESO schemes
5
Conclusion
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Base contract
Base contract
Contract specication
The benchmark contract specication is formulated as a
standard European call option:
max
_
S(T)
S(0)
K, 0
_
:=
_
S(T)
S(0)
K
_
+
in which K is the xed strike of the ESO.
We use relative stock price performance as the underlyings of
ESOs
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Parisian ESO
Parisian ESO
Contract specication
Under a Parisian scheme, the managers owns the following
option:
h(S(T)) = max
_
S(T)
S(0)
K, 0
_
1
{T
+
B
<T}
where T
+
B
gives the rst time at which an excursion above B
t
lasts more than d units of time
T
+
B
=inf
_
t > 0

_
t g
S
B,t
_
1
{S(t)>B(t)}
> d
_
< T
g
S
B,t
=sup{s t|S(s) = B(s)},
An exponential barrier B(t) = B(0)e
gt
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Parisian ESO
Parisian ESO
0 0.5 1 1.5 2 2.5 3
0.85
0.9
0.95
1
1.05
1.1
1.15
1.2
1.25
1.3
1.35
Parisian Up!and!in Call
Time
A
s
s
e
t

P
r
i
c
e


Asset Price
Strike K
Barrier L
d
T
B
+
Parisian Up-and-in call
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
Asian ESO
Basic idea
Under an Asian scheme, the executives compensation is
related to the average performance of the stock price
The basic idea is that the managers are rewarded only when
the average rate of return of the stock exceeds a xed rate of
return
Under this scheme, it is very unlikely that the executives can
benet from a one-time manipulation of the stock price
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Unconstrained average return ESO
Unconstrained average return ESO
Payo
The bonus indicator depends on the periodic rates of return:
_
N1

i =0
S(t
i +1
)
S(t
i
)
K(N)
_
+
K(N) can be eventually formulated as K(N) = N(1 + )
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Constrained average return ESO
Constrained average return ESO
Idea
It is economically sound to require that not only the average
rate of return shall be larger than a pre-specied value but
also the total return.
The idea behind this is that the arithmetic average is always
larger than the geometric average
Example:
In t
i
= iT/N for i = 1, ..., N 1 rms value grows at rate c.
In t
N
= T rm goes bankrupt.
average return is c(N 1)/N > 0
total return is 0!
It is possible that the average rate of return is larger than 1
while actually in total the company makes losses.
In this case it would be economically doubtful to pay the
manager a bonus
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Constrained average return ESO
Constrained average return ESO
Payo
The contract payo:
_
N1

i =0
S(t
i +1
)
S(t
i
)
K
1
_
+
1
n
S(T)
S(t
0
)
K
2
o
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Valuation
Risk-neutral pricing
Valuation
Under the risk-neutral probability measure Q, the price
process of the rms assets {S(t)}
t[0,T]
follows a geometric
Brownian motion
dS(t) = S(t)(rdt + dW
t
)
The arbitrage-free price of the contract payo is
E
Q
_
e
rT
Payo
_
S(t)
t[0,T]
_
_
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Valuation
Valuation
Pricing Formulas
Base contract: Standard Black-Scholes formula
Parisian ESO: Implied barrier concept (Anderluh and van der
Weide (2004) )
Approximate a Parisian up-and-in option with an up-and-in
barrier option with higher barrier
Asian ESO: Conditioning approach (Rogers and Shi (1995)
and Nielsen and Sandmann (2003))
unconstrained Asian ESO: Pricing bounds
constrained Asian ESO: Exact price
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Valuation
Numerical results for Parisian ESOs
0.0 0.1 0.2 0.3 0.4 0.5
0.15
0.20
0.25
0.30
0.35

UaI Parisian Call and BS Call for T3

d1
d12
d14
d112
BS
Up-and-in Parisian call and plain vanilla call as a function of for dierent d values with parameters:
S(0) = 100, B(0) = 110, T = 3, r = 0.05, g = 0.02, K = 1.0.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Valuation
Numerical results for Asian ESOs
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
0.005
0.01
0.015
0.02
0.025
0.03
0.035
!
P
r
i
c
e
Price as a function of !


Contract 3 upper bound
Contract 3 lower bound
Contract 4 price
Contract 4 Monte Carlo
Contract 3 Monte Carlo
Price of
1
N
Asian calls of contract 3 and contract 4 as a function of
with the same parameters N = 12, T = 3, r = 0.05, K
1
= N, K
2
= 1.1.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Comparison
Comparison among dierent schemes
Idea
When ESOs are granted the companys rms value process
has a xed volatility, e.g. = 0.2.
The manager can decide about dierent investment
opportunities or new strategies for the company.
Dierent choices of .
Assumption: Perfect hedgeability
The managers decision is based on the market value of his
stock options.
If the market value of the ESOs increases substantially by an
increase in the volatility, the manager would more eagerly
accept a more risky asset
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Comparison
Comparison among dierent schemes
... Idea
The payo schemes must have the same costs for the
company at time t = 0
we adjust the number of options in a portfolio
The next problem is that each option has certain parameters
which do not have a counterpart in the other options.
Fix the strike of all options to be K = 1.2.
g = 0.02, K
1
= 1.0, N = 12, T = 3, d = 0.25 or d = 0.5 i.e.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Comparison
Numerical illustration
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
!
n
o
r
m
a
l
i
z
e
d

p
r
i
c
e
Comparing the normalized price as a function of !


Contract 3
Contract 4
Plain vanilla call
Parisian call exponential barrier
Parisian call constant barrier
Normalized prices of portfolios of
1
N
Asian calls of contract 3 and contract 4, plain vanilla call options and Parisian
calls with exponential (g = 0.02) and constant barrier (g = 0) as a function of .
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Comparison
Remarks
Imposing restrictions
Our ndings are not trivial:
Imposing some additional restrictions on the path to the
vanilla call does not automatically reduce the sensitivity to the
volatility.
Two eects of restrictions:
May decrease sensitivity of a single option
Decreases the price of a single option (i.e. increases number
of options in the portfolio)
The whole portfolio can become more or less sensitive
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
New risk measure
Risk measure
Idea
Denote by f () the price of a single option depending on the
volatility. We have chosen the number of options of a
certain kind such that
f () = c
c > 0 is a constant
The slope of the portfolio is given by
f

() =
cf

()
f ()
.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
New risk measure
...Risk measure
Denition
The risk sensitivity of the price function f () of an option
on the volatility interval [
1
,
2
] with
1

2
is dened as
(f ,
1
,
2
) = (f ,
1
) =
f

(
1
)
f (
1
)
if
1
=
2
(f ,
1
,
2
) =
_

2

1
f

()
f ()
d if
1
<
2
=
1

1
log
_
f (
2
)
f (
1
)
_
The higher the higher the sensitivity of the price for changes
of in the given interval.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
New risk measure
Some numbers
constrained Asian Parisian Standard call

K
2
= 1.2 K
2
= 0.9 d = 0.25 d = 0.5 K = 1.2 K = 1.3
(f , 0.1, 0.3) 2.0801 2.7272 6.0467 5.6299 6.2651 8.7144
(f , 0.15, 0.25) 1.4199 2.7762 5.4231 4.8213 5.7079 7.5763
(f , 0.2, 0.2) 3.2963 2.7842 4.8925 4.7564 5.5572 7.2878
(f , 0.3, 0.3) 2.3174 2.2417 3.2832 3.2631 3.5234 4.2442
(,
1
,
2
) for dierent ESOs with parameters. All ESOs have in common: T = 3, r = 0.05. For the Parisian
case we have S
0
= 100, B
0
= 100, T = 3, r = 0.05, g = 0.02, K = 1.2 and for the constrained Asian case
N = 12, K
1
= 1.0.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Conclusion
Concluding remarks
Results
We introduce three new performance-vested executives stock
option schemes: Parisian and two Asian schemes
We have focussed on the valuation of these new ESO
schemes.
Closed-form solutions for Parisian and constrained Asian ESOs
Very accurate bounds for unconstrained Asian ESOs
We introduce a new risk measure to study the risk sensitivity
of the ESOs.
Parisian and Asian ESOs are less risk sensitive than the plain
vanilla options.
Both schemes can prevent a rms executives from taking on
too large risks
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Conclusion
Future research
Extensions
Analyze the managers decision in a utility based framework
(taking into account the potential unhedgeability of ESOs and
tradeos between risks)
Compare more options (e.g. American type call options)
Measure sensitivity risk in a dynamic setup
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Base contract
Valuation of the base contract
Under the risk-neutral probability (also called equivalent
martingale) measure Q, the price process of the rms assets
{S(t)}
t[0,T]
follows a geometric Brownian motion
dS(t) = S(t)(rdt + dW
t
)
The arbitrage-free price of the contract payo is
E
_
e
rT
_
S(T)
S(0)
K
_
+
_
=(d
1
) Ke
rT
(d
2
)
d
1/2
=
ln
1
Ke
rT

1
2

2
T

T
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Parisian ESO
Contract payo
Under a Parisian scheme, the managers owns the following
option:
h(S(T)) = max
_
S(T)
S(0)
K, 0
_
1
{T
+
B
<T}
where T
+
B
gives the rst time at which an excursion above B
t
lasts more than d units of time
T
+
B
=inf
_
t > 0

_
t g
S
B,t
_
1
{S(t)>B(t)}
> d
_
< T
g
S
B,t
=sup{s t|S(s) = B(s)},
An exponential barrier B(t) = B(0)e
gt
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Parisian ESO
Valuation: Implied barrier concept
For valuation, we rely on the implied barrier concept
(Anderluh and van der Weide (2004))
We approximate the expected payo of a standard Parisian
up-and-in option by the expected value of a standard
up-and-in barrier option:
E[e
rT
h(S(T))] =E
_
e
rT
_
S(T)
S(0)
K
_
+
1
{T
+
B
<T}
_
E
_
e
rT
_
S(T)
S(0)
K
_
+
1
{
B
<T}
_
where
B
:= inf{t|S
t
= B

t
}, i.e.
B
is the rst hitting of
the asset price on the implied barrier B

with
B

0
:= B
0
exp
_

de

m
2
d
2
_

2
_
and B

t
= B

0
e
gt
.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
Payo of unconstrained Asian ESO
The bonus indicator depends on the periodic rates of return:
_
N1

i =0
S(t
i +1
)
S(t
i
)
K(N)
_
+
with K(N) N.
K(N) can be eventually formulated as K(N) = N(1 + )
Todays arbitrage-free price equals the expected discounted payo
under the risk-neutral measure Q
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
Lower pricing bounds of unconstrained Asian ESO
A lower bound can be achieved by the conditioning approach
presented in Rogers and Shi (1995) and Nielsen and
Sandmann (2003). The starting point is the inequality:
E
_
_
_
N1

i =0
S(t
i +1
)
S(t
i
)
K
_
+
_
_
=E
_
_
E
_
N1

i =0
S(t
i +1
)
S(t
i
)
K
_
+

Z
_
_
E
_
_
E
_
N1

i =0
S(t
i +1
)
S(t
i
)
K

Z
_
+
_
_
=:C
l ,Z
(K, T)e
rT
where Z is an F
T
-measurable Gaussian random variable. We
set Z =
W
T

T
.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
...Lower pricing bounds
Proposition
Given equidistant time periods the lower bound C
l ,Z
(K, T)
obtained by the conditioning approach is
C
l ,Z
(K, T) = Ne
r (
1
N
1)T
(d
1
) e
rT
K(d
2
).
with
d
1
=
N log(N/K)

T
+
r

+
1
2

T
N
, d
2
= d
1

T
N
.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
Contract payo and valuation of constrained Asian ESO
The contract payo:
_
N1

i =0
S(t
i +1
)
S(t
i
)
K
1
_
+
1
n
S(T)
S(t
0
)
K
2
o
The price equals the expected discounted payo under the risk
neutral measure Q:
C
A2
(K
1
, K
2
, N) = e
rT
E
_
_
_
N1

i =0
S(t
i +1
)
S(t
i
)
K
1
_
+
1
n
S(T)
S(t
0
)
K
2
o
_
_
with T = t
N
.
Introduction Contract specication Valuation Comparison among dierent schemes Conclusion Appendix
Asian ESO
Pricing (K
2

_
K
1
N
_
N
)
Proposition
If K
2

_
K
1
N
_
N
we can give an explicit formula for the price:
C
A2
(K
1
, K
2
, N) = Ne
rT
(
1
N
1
)
_
(d
K
2
+

T)

Ke
rT
(d
K
2
)
_
with

K =
K
N
exp
_
rT
_
1
N
1
__
, = /N