What do Semtech’s Wylie Plummer, Microsoft co-founder Paul G. Allen and CNET Networks’ founder Halsey M. Minor have in common? According to news reports, they have all hedged their executive stock options over the past 18 months in order to move into more diversified portfolios. Given the recent volatility in the stock market and the amount of equity such individuals hold, it’s not surprising that executives are taking steps like these to minimize their risk, say Wharton researchers.

“There are benefits to diversification for many managers,” notes Wharton accounting professor David Larcker, “and it would be desirable to have a well-functioning market that enables managers to sell their stock options at a rational price and with minimal transaction costs.” While the stock market provides such a vehicle for shares owned by executives, “no such market currently exists for managerial stock options, which typically have a life of ten years.”

That, according to Larcker, doesn’t make sense. Since managers are going to hedge their portfolios anyway, he asks, “why not help them out by creating a market for their stock options?”

The Stock Options Explosion

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.

My Stock Options Are “In the Money”! Now What?

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?

First, an employee can hold on to the options. While this may seem beneficial to shareholders (the employee’s feet are still being “held to the fire”), this can actually be detrimental to shareholders’ interests. That is, exposing employees to some risk can be beneficial, but exposing them to too much risk can be damaging to both parties. Employees hold extremely undiversified portfolios (taking into account their human capital) relative to shareholders, and huge “in the money” option packages exacerbate their lack of diversification. To reduce this exposure to risk, employees may be motivated to make investment, financing and operating decisions that use the company’s resources to diversify his personal portfolio of wealth. According to Wharton accounting professor Richard Lambert, “A manager can reduce the risk of his portfolio by completing an acquisition that has a low economic expected return (which is bad for shareholders), but which substantially reduces the volatility of future cash flows and stock price (which is good for the manager).”

Similarly, a manager can forgo investment in promising research and development that has a high expected economic return, but also a correspondingly high risk. Shareholders may find this investment to be highly desirable because they can diversify part of the risk, whereas managers may view this same investment as undesirable because they have no ability to shed the risk with a highly undiversifed portfolio.

There are many examples of such behavior in practice. One of the more compelling actual illustrations involves a consumer products company that was in bankruptcy negotiations. The board of directors decided to hire a well-known manager in an attempt to turn the company around. This manager made a sizeable personal investment in company stock and was given several million stock options at a very low exercise price. The manager revamped the company’s strategy and implemented a number of high risk capital investments. Within several years, the investments were a great success and the company’s stock price rebounded to levels well above the previous historical high.

So what’s to complain about? The manager had a substantial equity investment in the company and investment decisions were made that increased the stock price. Unfortunately, once this manager’s stock and stock options were now worth many times their initial value, this manager’s behavior changed from risk seeking to risk aversion. After the economic success, this manager no longer sought to take the high risk-high return investments that shareholders desired, but rather began to concentrate on small and safe incremental projects. Obviously, this change in investment strategy was desirable to the manager because it enabled him to “bank” the economic gain from his highly undiversified portfolio by not subjecting it to large risk.

Clearly, the initial equity investment provided considerable incentives to the manager to increase the stock price. However, this same investment after the success retarded these same incentives. The interesting (and somewhat controversial) solution proposed to the board of directors was to let this manager diversify his personal portfolio by “cashing out” his stock options, and then provide him with another set of options at the new (and higher) exercise price. In this example, the board proactively helped the manager diversify in order to avoid the undesirable decisions made by a manager with “too much” equity in his personal portfolio.

Hedge the Stock Options

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).

Exercise and Sell The Stock Options

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.

Expanding the Market For Publicly Traded Stock Options

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.”

Richard Lambert and David Larcker, who have done extensive research on this topic, are encouraging readers to share their opinions on the following three questions:

  • Do you think that managers should be able to sell (or hedge) some of their stock options (as opposed to merely exercising them) in order to diversify their personal wealth?
  • Would a liquid and well-functioning market for expirationless stock options (XPOs) be useful for enabling managers to diversify?
  • Would changing an employee stock option from having ten-year terms to being expirationless have positive or negative performance consequences for the firm?

Please send any comments and ideas about this topic to Richard Lambert and David Larcker at respond@credit.wharton.upenn.edu All comments will be confidential and used only for research purposes.