Hedging Their Risk: Creating a Market for Managerial Stock Options

The use of employee stock options in compensation packages has dramatically increased over the last 10 years. Option packages are now often the largest component of compensation at the top executive level, and option packages are becoming increasingly large parts of compensation for lower level employees as well. While there is still considerable debate about the merits of option packages, they are purported to have a number of benefits: Options motivate employees to take actions that are in the interests of stockholders because they link employee pay to stock price performance; options motivate employees to remain with the firm longer and also adopt a longer term horizon in their decision-making because of the vesting feature of options; option packages allow companies to attract talented employees; options do not require the company to make a cash payout, and options granted “at the money” (i.e., with an exercise price equal to the stock price at the date of grant) do not require the firm to recognize compensation expense on their income statement.

Of course the payoff from an option ultimately depends on how future stock price performance compares to the option’s exercise, or grant, price. As such, options can be an extremely risky form of compensation. The upside can be tremendously high; virtually all of the executives that appear in surveys in the business press of the most highly paid executives are there because of the payoff they received from their options, not from having received large salaries or bonuses. At the other extreme, many options packages have become worthless because the stock price plunged after the options were granted, as was the case for many NASDAQ firms in the spring of 2000.

Since no one can predict what will happen to a firm’s stock price, attempting to place a value on options ahead of time must be based on estimates of the likelihood of different scenarios for stock price changes. Option valuation is very important to many decisions an employee faces, such as evaluating a prospective compensation package or deciding whether to hold options or exercise them. Yet employees are often notoriously bad at valuing option packages. They can’t, for example, simply look up the value of their options like they can look up the value of (say) restricted stock, because there are no comparable options that are traded out in the stock market. That is, publicly traded options generally have very short times to maturity, and do not have common institutional features like vesting and forfeiture requirements that are incorporated in most employee stock options. Moreover, models of option pricing do not take into consideration the likelihood that employees will often want to cash out of their option position before the exercise date.

Of course, all employees want their stock price to rise above the exercise price so they can receive a payoff from their options. However, once an option goes “into the money,” the employee’s exposure to risk can significantly increase. In particular, if the stock price falls, the employee loses his “paper gain” and options now have “downside risk.” What are an employee’s investment alternatives?

An alternative way to reduce the employee’s exposure to risk is to take positions in other securities to hedge this risk. The most direct hedge is, of course, to short-sell your own stock; if the stock price falls, the decline in the value of the options will be offset by the gain from the shorted shares. Not surprisingly, the Securities and Exchange Commission (SEC) forbids officers and directors from short selling their own stock. However, it is not illegal for lower level employees to do this. Unfortunately, the transactions costs associating with shorting can be high (through, for example, margin requirements).

In order to not violate SEC rules, managers can use synthetic instruments such as caps or collars (with appropriate SEC disclosure) to implement a hedge. For example, a manager could buy put options with an exercise price at or below the current stock price) and sell call options (to finance the purchase of the puts). If the stock price falls, the loss in the value of his employee options is (at least partially) offset by the gain in the value of the put options. In addition to transaction costs, another drawback to this strategy is that if the stock price rises, the manager does not benefit from the increase (because the gain on his employee options is offset by the loss on the call options he sold).

Of course, to be able to perform these hedges, the employee must be able to find a traded security with the desired expiration date and exercise price. Again, the lack of markets for a rich variety of option contracts can make this difficult. Alternatively, some forms of hedging for stock and stock options allegedly occurs directly between managers and various investment banks. For example, a manager may exchange the payoffs from a large option grant for direct cash payments or the promise of future payments related to the performance of a diversified investment portfolio. The problems with this approach are that the transaction fees paid to the investment bank are likely to be especially large, and thus personally costly to the manager. Moreover, the external disclosure of these personal “hedging contracts” is haphazard (i.e., it is difficult to find these transactions disclosed in SEC reports, although discussion of such hedging is common among investment bankers).

The last alternative for reducing exposure to risk is to simply exercise the option. Of course, if the option is merely transformed into shares, the risk problem remains. However, even if the employee cashes out, there is still a cost to this strategy. Specifically, an employee who exercises his options prior to the expiration date generally forfeits a considerable portion of the value of his option. That is, virtually all option valuation formulas state that the value of the option is worth more than the option’s “intrinsic value” (i.e., the difference between current stock price and the option’s exercise price for an “in the money” option.)

With publicly traded options, investors who wish to “cash out” do not have to incur this penalty because they have the ability to sell the option to someone who can continue to hold it. If employees who need cash (for liquidity reasons) or want to reduce their exposure to risk were allowed to sell their options (either back to the firm or on the open market) for their market price instead of having to exercise the options, they would not have to bear this cost. Of course, for this to be feasible, there must be a viable market for “identical” options to establish a fair price for the option.

The lack of well functioning markets for securities like employee stock options makes valuation and risk reduction strategies problematic. Although not available now, a new approach for hedging employee stock options is being developed by Economic Inventions LLC., a Philadelphia-based financial consulting firm which has obtained several recent patents on expirationless call options (or XPOs) that will soon be traded on major exchanges. The company describes XPOs as stock options that “will provide a new vehicle for creating stock price performance incentives for executives and employees.” Since XPOs will be actively traded in a public market, it will be less costly to hedge managerial stock options, says Lambert. Moreover, the traded prices will provide an explicit market price to gauge option value, something that is presently only a speculation with managerial stock options that are not traded, he adds.

However, one important difference between XPOs and employee options is that employee stock options generally have terms of ten years, whereas XPOs have no expiration date. From a market-making perspective, the advantage of expirationless options, says Larcker, is that you don’t need a separate market for each possible expiration date. Although existing stock option programs would need to be amended to use XPOs and allow managers to transfer their options, the ability to have a rational market price for a long-term stock option enables managers to appropriately hedge their stock options.

“Given the unusual instability of the equity markets these days,” Larcker notes, “it might be time for the compensation committees of boards of directors to take a serious look at the economic advantages of new strategies for hedging risk.”