Valuing Derivatives

Sally Jameson: Valuing Stock Options

in a Compensation Package

By: Ravindra Pandhey, VU EF Finance I Course

2017 October 3
 Content

Introduction to Case Study

Given Facts
Analysis
Choice I for Sally
Choice II for Sally
Important Considerations
Other Strategy in Case of Choice II
Recommendation
2017 October 3 VU Ekonomikos fakultetas
 Introduction to Case Study
Sally Jameson a 2nd Year MBA student at Harvard Business School in May
1992 got a desired job offer from a multinational telecommunications
company Telstar. Salary offer described by MBA recruiter of the company –
• Salary of 50000 Dollars non-negotiable.
• Signing bonus of 5000 Dollars or Stock Options, only one option is allowed.
• This is the first time company offering Stock Options to MBA students.
• 3000 Stock Options will be granted which can be exercised only after
successful completion of 5 years with the company then power to exercise
will give 1 share @ 35 dollars only.
• Confusion state for Sally due to not much information being provided by
recruiter and she has to decide in one day either Cash or Stock Options.
• Recruiter gave the current price of company is 18.75 dollars and no dividend
payout policy and in future also no hope for dividends.
• Sally needs help.
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 Given Facts

Sally tried to extract some information from a journal WSJ and

this is the only limited information for the case on the basis of
which we need to analyze. Given Facts are –
1) Current May month 1992 and 3 months strike price option
premiums.
2) Long Term strike price option premiums with expiry of two
years.
3) Stock Price history of Telstar company from 1982 to 1992.
4) Volatility history of Telstar company stock from 1982 to 1992.
5) Annualized Treasury Bill Interest Rates as of May 1992.

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 First Fact
Listed Telstar Options Quotations as of Close of Market - May 27, 1992

Expiration Date (1992)

Strike Price June 20 July 18 October 17

17.5 Dollars 1.4375 1.875 2.5

20 Dollars 0.1875 0.5 1.31

22.50 Dollars NT* 0.125 0.5625

*NT - Not Traded, it is liquidity problem in Options Trading

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 Second Fact

Long Term Call Options

Expiration Date Strike Price Option Price

January 22, 1994 12.50 Dollars 7.75

January 22, 1994 17.50 Dollars 4.62

January 22, 1994 20 Dollars 3.75

•As we can see these options are having expiry of two years from the year 1992
•12.50 and 17.50 Strike Prices are In-The-Money Call Options (ITM)
•20 Strike Price is Out-Of-The-Money Call Option (OTM)

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 Third Fact
Stock Price History of Telstar Company from 1982 to1992

Highest Price 35 (1989-90), 15 touched (1988), Average Price around 20

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 Fourth Fact
Volatility History of Telstar Company from 1982 to1992

Highly Volatile between 1988 to 1992 in the range of 80% - 30%

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 Fifth Fact
Treasury Security Yields as of May 27, 1992

TIME INTEREST RATES

1 Month 3.70%
2 Months 3.72%
3 Months 3.69%
6 Months 3.81%
1 Year 4.02%
2 Years 5.25%
5 Years 6.02%
7 Years 7.08%
10 Years 7.41%
30 Years 7.89%

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 Analysis
Sally has a choice to choose either cash signing bonus of 5000 dollars or 3000
Stock Options but these options with a condition to stay 5 years in a
company.
Choice I: Accepting cash 5000 Dollars
• Utilize cash for personal use after capital gains tax rate of 28%
• Invest Cash for 5 years with an Interest Rate of 6.02% on Treasury Bonds
Choice II: Accepting Stock Options quantity 3000 and wait for 5 years to
exercise and convert into stock @ 35 dollars for 1 share.
• At the end of 5 years Expected Future Stock Price
• Expected growth of company
• Use of Hedging strategies in Call Options
Recommendation: It is based on analysis of both choices and then choosing
the most suitable option for Sally.

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 Choice I
• If Sally chooses cash signing bonus of 5000 dollars and wants to utilize that
cash immediately, then she will receive -
 5000 * 28% Tax = 1400
 5000 – 1400 = 3600 (Ready Money for Sally as Cash in Hand)

• If she wants to invest 5000 dollars for 5 years in the Treasury Bonds with an
Interest Rate of 6.02% then she will receive after 5 years –
Future Value = Invested Amount * {(1+Rate of Interest)Time }
 5000 * {(1 + 0.0602)5}
 6697.44 at the end of 5 years
Same can be done by clicking on the below link of calculator online –
https://www.calculatestuff.com/financial/compound-interest-calculator

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 Choice I

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 Choice I
If Sally would have opted Stock Options then what is the value of her options money in
comparison to Cash Bonus.
Calculation of Options Price with respect to Current Market Price with the help of Black
Sholes Model (BSM). Inputs for BSM -
• Current Underlying Price (18.75 Dollars)
• Options Strike Price (35 Dollars)
• Time until Expiration (5 Years)
• Implied Volatility (30% from Fourth Fact)
• Risk-free Interest Rates ( 6.02% from Fifth Fact)

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 Choice I
Black Sholes pricing is very complex so click on the below link for options price
https://www.mystockoptions.com/black-
scholes.cfm?ticker=&s=18.75&x=35&t=5&r=6.02%25&v=30%25&calculate=Calculate
Result will be – Black Sholes Calculator

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 Choice I
Now the value of 3000 Stock Options at the current price the Option Price as
per BSM is –
Option Price = 2.92 Dollars
 3000 * 2.92 = 8760 Dollars (without tax rate & transaction rate)
Originally Cash Compensation was 3600 after 28% Tax but Stock Options
Compensation value is much higher than Cash but biggest condition for Sally
is she cant sell Stock Options until 5 years.
Choice I suggests in the event of urgent utilization ‘Cash Compensation’ is a
better option.

Right Wrong

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 Choice II
If Sally wants to stay with the company for 5 years and opts 3000 stock
options then what would be the scenario after 5 years. These are European
Style Options because she can not sell before expiration period. She will
exercise the option only when the company stock price will cross 35 dollars
which is the highest price and just touched only once (as per stock price
history).
What should be the fair value she needs the stock price should reach to?
=> 5000 * (1+0.0602)5 = 6697.44
 3000 (Fair Price – 35) = 6697.44
 37.23 Dollars
In order to have the same profit as that of cash compensation, the
stock price must rise up to 37.23 dollars then only stock options would
be worth exercising.

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 Choice II
To reach up to 37.23 dollars the company needs how much growth ?
The company has no dividend history so we cant apply any growth model but we
can calculate the expected Compound Annual Growth Rate (CAGR).

CAGR = (37.23/18.75) (1/5) - 1

CAGR = 1.14 – 1 = 0.1470 *100 = 14.70%

Company has to grow almost by 15% every year to reach the price up to 37.23
which is a very difficult task as seen the stock price history.

Choice II is also exhibiting difficulties in reaching price to 37.23 dollars.

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 Important
Considerations
• Stock Options do look lucrative but the pricing calculation is not easy
because all indications show probability but not certainty.
• Options Liquidity – Liquidity is a very important factor in options trading
because it helps in understanding how much people are keen in options strike
price. As we have seen in “First Fact” the 22.50 Strike Price for 2 years
expiry there were no trades at all. As the current stock price increases the
future strike prices open in the market for trading.
• Tax Rates – As we have seen Capital Gains Tax Rate was 28% even on cash
compensation and even on Stock Options when it will get converted into
stocks then if Sally sells stock immediately after exercise options then tax rate
will get applied. She has to keep stock for 1 year after exercising to avoid tax.
• European Style Options are those options which can be exercised only at
expiry like Sally has lock in period of 5 years so these options are European.

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 Other Strategy in Case
of Choice II
• If Sally has a good understanding of Options Trading then despite of risky Stock
Options she can apply Options Hedging Strategies every year to avoid the
opportunity loss.

Options Strategy - Selling/Writing Out-Of-The-Money (OTM) Call Options

• Every year there are strike prices open above the current market price like in the “First
Fact” there was OTM Strike Price of 22.50 so she can sell the option and pocket the
premium. If current market price doesn’t reach to that same Strike Price whose
Option premium which already sold then it would be profit at expiry.
• If current market reaches to that OTM strike price then it would be loss but eventually
underlying stock price is increasing.
• While selecting higher OTM strike prices Implied Volatility (IV) gives good indication
of bullish or bearish sentiment of market. If IV is high then sentiment is bearish which
is always good for Writing OTM Call Options.

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 Other Strategy in Case
of Choice II
Writing OTM Call Option
From the second fact we take Jan 22 1994 Strike Price 20 Dollars OTM
20 Dollars (Strike Price) => 3.75 (Option Premium)
 3000 * 3.75 = 11250
If Sally write the OTM Call then premium collection is 11250. Now there will be two
scenarios for covering position -
Scenario 1
If stock price till expiry date Jan 22, 1994 does not reach to 20 then all profit of 11250

Scenario 2
If stock price crossed 20 then loss starts from the level of 20 till the closing price * 3000.

• Margin Money is needed to write OTM Call Options because it is considered as short
position without underlying stock. Even if Sally wants to cover short position then
LIQUIDITY in that strike price has to be there in any given point of time.
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 Recommendation

After analyzing both the choices based on limited facts available, the best would be
CHOICE 1 for Sally that is choosing Cash Compensation
because -
• Cash component has much more promising worth than stock options and important
fact is she cant sell stock options immediately after joining.
• We had seen from stock price history 35 just touched once so imagine to reach 37 in
order to get good profit more than cash component is almost a very vague possibility.
• The volatility in stock is huge which creates ripples in mind and hesitation to choose
stock options.
• Post tax Cash compensation is 3600 and post tax Stock Options worth would be 6307
in case of immediate selling then (6307-3600=2707) so in order to get 2707 more
waiting period of 5 years is a very risky venture and totally uncertain but opting Cash
component gives 3600 which is very much profitable and certain. Rather she can
invest Cash for 5 years and earn handsome 6697.
• Hedging Options is very tedious task which also involves lot of risk and big margin
money with heavy transaction costs.
2017 October 3 VU Ekonomikos fakultetas