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8- 1. Chapter 8 Options and Convertible Securities. Definitions 8- 2. An Option is a contract giving the holder the right to buy or sell an asset at (or before) a future date at a specified price.

andrew-james
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  1. 8-1 Chapter 8 Options and Convertible Securities

  2. Definitions 8-2 • An Option is a contract giving the holder the right to buy or sell an asset at (or before) a future date at a specified price. • . A Call Option is a contractual right to buy an asset at a specified price on (or before) a specified date. • . A Put Option is a contractual right to sell an asset at a specified price on (or before) a specified date. • . The Expiration Date is the last date on which the option may be exercised; after that it carries no rights. • . An American Option is a contract that allows the holder to buy or sell an asset on or before the Expiration Date. • . A European Option is a contract that allows the holder to buy or sell an asset only on the Expiration Date. • .Exercise or Strike Price is the price at which the holder of an option can buy or sell the asset. • . A Warrant is a call option issued by a company with respect to its own securities.

  3. Real Options 8-3 • The ability to alter a project during construction or development. • The ability to breach a contract and pay damages. • A debtor’s ability to default and sell assets to creditors. • A debtor’s ability to pay off debt and “buy” assets from creditors. • Oil & gas leases. • Options to purchase real estate (often pending rezoning or assembling of a larger tract, or a loan).

  4. Value of Long Position 8-4 • Value of Long position • $150 • $100 • $50 • 45 degrees • 0 • $50 $100 $150 Stock Prince

  5. Value of a Short Position 8-5 • Value of Short Position $0 $50 $100 $150 Stock Price • 45 degrees • - $50 • -$100 • - $150

  6. Table 8-1 Quotations on Options on IBM Stock 8-6 • -Call- -Put- • Option / Strike Exp Vol Last Vol Last IBM • 50 Oct 68 13.40 1505 0.15 63.92 • 50 Nov 54 13.60 1925 0.85 63.92 • 55 Oct 1061 8.90 5883 0.40 63.92 • 55 Nov 1037 10.10 5576 1.50 63.92 • 60 Oct 7646 4.80 12074 1.05 63.92 • 60 Nov 2952 6.30 4333 2.65 63.92 • 65 Oct 11041 1.60 4089 2.90 63.92 • 65 Nov 4127 3.50 1832 4.70 63.92 • 65 Jan 2510 5.70 908 6.90 63.92 • 70 Oct 3687 0.35 717 6.90 63.92 • 70 Nov 5292 1.45 341 8.20 63.92 • 70 Jan 2233 3.60 199 10 63.92

  7. Fig. 8-3 Value of European Call Option @ $1008-7 • Value of • Call • $150 • $100 • $50 • $0 $50 $100 $150 Stock Price

  8. Fig. 8-4 Value of Position of Call Writer at Expiration8-8 • Value of • Position • $50 $100 $150 $200 stock price • $0 • -50 • -$150 • -$200

  9. Fig. 8-5 Value of Put Option to Holder at Expiration 8-9 • Value of • Call • $150 • $100 • $50 • $0 $50 $100 $150 Stock Price

  10. Quick Check Question 8.1 8-10 Using long and short positions in the other financial instruments, can you synthesize the position of the writer of a put option, to achieve the position shown in Figure 8-5?

  11. Quick Check Question 8.1 8-11 • Option: Stock Stock Stock • @ $100 @ $0 @$200 • 2 Call Options at $100 $0 (Strike price= $0 +$200 • Market Price) • Short seller’s position $0 (purchase price + $200 (covers at $0 -$200 = Sale price) keeps sale price) • Minus: • 1 put writer’s position $0 (+ option price) - $100$0(+OP) • Net: $0 +$100 $0 • Compare with Put Holder: $0 (loses option price) + $100 (sells @ $100)

  12. Quick Check Question 8.2 8-12 • How can you replicate a call option on the stock? Our investor can borrow $100 in cash (the equivalent of selling a zero coupon bond short), and buy a European call option to purchase IBM stock at $100. If the stock rises above $100, the investor exercises the option using the borrowed funds. If the stock falls below $100, the investor lets the call option expire and repays the loan with the borrowed $100 (ignoring interest for the moment). Can you demonstrate this in a payoff matrix? Can you diagram it?

  13. Quick Check Question 8.28-13 • Strategies on Expiration Date of European Call Option @ $100________ • Stock Price Rises to $110 Stock Price Falls to $90_______ • Keep loan proceeds $100 Repay loan $ 0 • Excercise call option ($100) Let call option expire 0 • Value of stock purchased $110 • Less loan to be repaid ($100) • Total: $10 $ 0

  14. Diagram of Quick Check Question 8.28-14 • Value of • Position • 110 • 100 • 90 • 90 • 70 • 60 • 50 • 40 • 30 • 20 • 10 • 0 • 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Stock Price

  15. What are main uses of options? 8-15 • Compensation. You can pay people in dollars. Or you can pay them in stock. • Believed to creates better incentives because they now have a stake in the company’s outcomes. • Stock payments to executives have to be accounted for as an expense, at the value of the stock. • This reduces earnings.

  16. What are main uses of options? 8-16 • Until recently, neither accounting standards nor the SEC required qualified stock options to be treated as an expense at the time the options were given. • On Dec. 4, 2004, the Financial Accounting Standards Board issued revisions to Statement No. 123, Accounting for Stock-Based Compensation, which required public companies to treat as an expense the fair value of stock option awards as of the grant date.

  17. What are main uses of options? 8-17 • The SEC has ruled that registered companies must begin to use this method for fiscal years beginning after June 15, 2005.

  18. What are main uses of options? 8-18 2. Options can also be used for hedging. • Suppose that you are invested in 10 shares of IBM, selling at $63.92, but you’re worried that it may decline.

  19. What are main uses of options? 8-19 • You could sell the stock today at $63.92, less commissions, and repurchase it at a lower price later, plus commissions, if it declines. • But if it rises, you’ll have to pay more to repurchase it, plus commissions. • Note that if you want to be an investor in IBM long term, you pay two commissions to trade in and out of the stock.

  20. What are main uses of options? 8-20 • An alternative is to hedge, by purchasing put options to sell the stock. See Slide 8-6 • You could purchase put options to sell at $60 up to the end of: • October for $1.05 • November for $2.65 • This is a modest insurance cost for protecting against losses. - A “hedge.”

  21. What are main uses of options? 8-21 • You could also sell short, using borrowed shares, which you could either cover with your own shares or with newly purchased shares at a lower price if the stock goes down.) • But this doesn’t cap your risk in the same way – if the stock price rises, your cost of covering your short position can be much higher than the cost of letting put options expire.

  22. Hedging 8-22 • Do directors have to care about hedging?

  23. Hedging 8-23 • Do directors have to care about hedging? • Yes. They can be found liable for breach of duty if they ignore it. Brane v. Roth, 590 N.E.2d 587 (Ind. App. 1992) (liable for failure to supervise hedging of a grain elevator).

  24. Problem, Page 556 8-24 The Freeze-Out at Zero Value. •  A business with a history of losses for several years, which is typical in this business. • At this time we can assume that the balance sheet net worth of the business is very low, if not negative. • The majority stockholder has been guaranteeing bank loans while your client, the minority stockholder, has not been participating. • The majority stockholder has obtained an opinion from a financial expert that suggests the business is worthless. • And the majority proposes to freeze your client out in a reverse stock split for a nominal sum. • What arguments can you think of that might suggest a positive value for the stock?

  25. Problem, Page 556 8-25 • This situation is clearly an option argument. • We have information that the market for Menhaden is highly cyclical, and that the cycles can often be several years long. •  This means there’s a reasonable expectation of profits some day. • Perhaps the best evidence of this is that the majority stockholder continues to guarantee bank loans. • Our majority stockholder, by guaranteeing the loans, has purchased an option to buy the assets from the bank, suggesting the option value is significant. How do you value it?

  26. Elements of Call Option Values 8-26 • The current price of the underlying asset (the price of stock, in the case of stock options); • The exercise price; • The time to the expiration date; • The variance of the price of the underlying asset; and • The risk-free interest rate.

  27. Fig. 8-10 Value of American Call Option @ $1008-27 • Value of • Call • $150 • $100 • $50 • Value of American Value of European Option Option • $0 $50 $100 $150 Stock Price

  28. Table 8-2 Expected Values of Stock8-28 • Value . Expected Value . • Stock A Stock B x Probability = Stock A Stock B • $90 0.5 $45 • $110 0.5 $55 • $70 0.5 $35 • $130 0.5 ____ $65 • Totals: $100 $100

  29. Fig. 8-11 Payoffs from Options on A & B 8-29 • Payoffs on • Call Options • Payoff on A • Options • Payoff on B • Options • $70$90 $100 $110$130Stock Price • Exercise Price

  30. Binomial Option Valuation Model8-30 • Assumptions: Current stock price $100 • 1-year European call option @ $100 • Stock price has equal chance of being at $80 & $120 in 1 year. • (10% interest rate) • Alternative 1 (Call Option): • Buy 1 option, which in 1 year will be worth $0(low) or $20 (high) • Alternative 2 (Leveraged Stock Purchase): • Borrow discounted present value of low bound ($80): $72.73 • Buy 1 share @ $100 now (your net investment = $27.27 • Outcomes: • Low ($80) stock value – minus loan repayment ($80) = $0 • High ($120) – minus loan repayment ($80) = $40 • Payoff on levered investment is 2 times the payoff on 1 call option. • Two call options = leveraged purchase investment ($27.27) • Value of one call option = $13.63.

  31. Scientific Atlanta’s Option Disclosures 8-31 • Stock Options • The following tables set forth certain information in the prescribed formats with respect to options granted under Scientific-Atlanta’s various stock option plans during fiscal year 2002. No Named Executive Officer exercised any options during fiscal year 2002. •   Option Grants in Last Fiscal Year •       Potential Realizable Value at Assumed Annual Rates of Stock Price Individual Grants  Appreciation for Option Term (1) Number of Securities % of Total Underlying Options Exercise Options Granted to or Base Granted (2) Employees Price Expiration FY 2002 ($/sh) Date 5%($) 10%($) Name • James F. McDonald 400,000 8.8 $22.10 2/16/2012 $5,559,429 $14,088,683 • 125,000 2.8 $22.10 2/16/2012 1,737,321 4,402,714 • H. Allen Ecker 50,000 1.1 $22.10 2/16/2012 694,929 1,761,085 • 20,000 0.4 $22.10 2/16/2012 277,971 704,434 • Conrad J. Wredberg, Jr. 75,000 1.7 $22.65 12/19/2011 1,068,335 2,707,370 • 75,000 1.7 $22.65 12/19/2011 1,068,335 2,707,370 • 40,000 0.9 $22.10 2/16/2012 555,943 1,408,868 • Dwight B. Duke 57,000 1.3 $22.10 2/16/2012 792,219 2,007,637 • 20,000 0.4 $22.10 2/16/2012 277,971 704,434 • Robert C. McIntyre 40,000 0.9 $22.10 2/16/2012 555,943 1,408,868 • 15,000 0.3 $22.10 2/16/2012 208,479 528,326

  32. 8-32 • The dollar amounts in these columns were determined using assumed rates of appreciation set by the SEC and are not intended to forecast future appreciation, if any, in the market value of Scientific-Atlanta common stock. Such amounts are based on the assumption that the named persons hold the options for their full ten-year term. The actual value of the options will vary in accordance with the market price of Scientific-Atlanta common stock. (2) All of these stock options were awarded under the LTIP. If a change of control occurs (as defined in the LTIP), all options become exercisable immediately. These options may be exercised within a period of three years following a termination by reason of retirement, within one year following a termination by reason of death or disability, and within thirty days following a termination for other reasons, except for cause, in which case such options expire immediately upon the giving of the notice of such termination. (3) Vests in four equal installments beginning on the date of grant. (4) Vests 100 percent on the sixth anniversary of the date of grant, but may vest earlier based generally upon the cumulative compound annual percentage increase in net revenues over three years. (5) Vests in four equal installments beginning on the first anniversary of the date of grant.

  33. SEC Office of Economic Analysis Comments 8-33 • “In a memo dated March 18, OEA advised that the valuation methods for the expensing of stock options are well known and the issues that may arise in implementing FAS 123R are not unusual since they also occur in other areas of accounting and finance. Current methods for valuing employee stock options are reliable and appropriate for compleing with FAS 123R, according to OEA. • * * * • “OEA cited evidence that the modified Black-Scholes-Merton approach provides reliable estimates of option value. The lattice, binomial and Monte Carlo approaches have advantages that make them more suitable for some companies.”

  34. Herbert Resnik v. Jerome Swartz 8-34 • The board approved the 2000 Directors Stock Option Plan, with options exercisable at the higher of the market price (1) on the date of board approval or (2) the date of shareholder approval. • Options on 50,000 shares exercisable over 4 years, with ¼ vesting annually. • Proxy statement disclosed full terms of plan, and included the SEC’s required chart showing valuations if the value of the stock compounds at 5% and 10%. • The Proxy statement also made the following value disclosures: “The actual value, if any, an executive will realize will depend on the excess of the market price over the exercise price on the date the option is actually exercised. The value actually realized by an executive or any shareholder may not be at or near the values estimated in this table.” • The shareholders approved the plan.

  35. Herbert Resnik v. Jerome Swartz 8-35 • Plaintiff alleges that the Black-Scholes valuation of the option grants on the date of grant was $2,868,000. - page 570. • Was the Proxy Statement materially misleading because it did not disclose the grant date Black-Scholes value of the options? No.

  36. Symbol Technologies’ Option Disclosures 8-36 • Individual Grants in 1999 Potential Realizable Value as Assumed Annual • Number of % of Total Rates of Stock Price Appreciation for Option Term(A) • Securities Options • Underlying Granted to Exercise 5% 10% • Options Employees in or Base Expiration Stock Dollar Stock Dollar • Granted (No.) Fiscal Year Price Date Price (I) Gain Price Gain • Name • * * * • Jerome Swartz 120,000 3.88% $38.67 2/17/09 $62.98 $2,918,074 $100.29 $7,394,971 • 195,000 6.31% $35.54 2/17/09 $57.89 $4,358,637 $92.19 $11,045,641 • CEO’s Gain as • % of All • Shareholders Gain .407% .407% • A. Total dollar gains based on the assumed annual rates of appreciation of the exercise price of each option. The gain derived by all shareholders is based on the outstanding number of shares at December 31, 1999. The actual value, if any, an executive will realize will depend on the excess of the market price over the exercise price on the date the option is actually exercised. The value actually realized by an executive or any shareholder may not be at or near the values estimated in this table.

  37. Questions 8-37 • What is the difference in disclosure requirements for stock options under Regulation S-K for executive officers and non-employee directors?

  38. Reg. S-K, Item 402(g) 8-38 • (g) Compensation of Directors -- • (1) Standard arrangements. Describe any standard arrangements, stating amounts, pursuant to which directors of the registrant are compensated for any services provided as a director, including any additional amounts payable for committee participation or special assignments. • (2) Other arrangements. Describe any other arrangements pursuant to which any director of the registrant was compensated during the registrant's last completed fiscal year for any service provided as a director, stating the amount paid and the name of the director.

  39. Reg. S-K, Item 402(c)8-39 • c) Option/SAR Grants Table. (1) The information specified in paragraph (c)(2) of this item, concerning individual grants of stock options (whether or not in tandem with SARs) and freestanding SARs (including options and SARs that subsequently have been transferred) made during the last completed fiscal year to each of the named executive officers shall be provided in the tabular format specified as follows: • OPTION/SAR GRANTS IN LAST FISCAL YEAR • [Individual Grants] • Name Number of Percent of total options/ Exercise or base Expiration date • securities SARs granted to price ($/Sh) • employees • underlying in fiscal year • options/SARS • granted (#) • (a) (b) (c) (d) (e) • OPTION/SAR GRANTS IN LAST FISCAL YEAR • Name Potential realizable value at Alternative to assumed annual rates of stock (f) and (g): • price appreciation for option grant date • term value 5% ( $ ) 10% ( $ ) Grant date presentvalue $ • (a) (f) (g) (f)

  40. Questions 8-40 2. Rule 408 under the Securities Act of 1933, which governs disclosures in registration statements (also governed by Regulation S-K) states: In addition to the information expressly required to be included in a registration statement, there shall be included such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading. Would this rule make a difference if suit had been brought by a securities buyer in a public offering? Probably not. The SEC has probably resolved that issue, even for executives, by providing disclosures in the alternative – either the 10 year appreciated values, or the grant date present value.

  41. Questions 8-41 • Should the sheer magnitude of the value of the present value of the option grants alleged by Resnik make a difference in the determination of whether the disclosures of contract terms, without more, was misleading? • The court rejects that argument by noting that no claims were made about the value of the options on the grant date. • The company did what was required for non-executive directors, which didn’t require any showing about values.

  42. Questions 8-42 • Symbol was a Delaware corporation. Malone v. Brincat, 722 A.2d 5 (Del. 1998), stated that “[t]he directors of a Delaware corporation are required to disclose fully and fairly all material information within the board’s control when it seeks shareholder action.” Id. at 12. Could plaintiff have successfully pleaded a state law claim? What arguments would you make on behalf of the plaintiff? • Yes, that the board had breached its fiduciary duty of disclosure of the value directors’ compensation at the time granted. • This is inherently a conflict of interest situation, which places the burden on directors to show the entire fairness of their actions. • One could argue at state law that the directors failed to make fair disclosures to the shareholders (see Weinberger v. UOP for rules about fair dealing and disclosures).

  43. Protecting Options 8-43 • Anti-Destruction: Language to protect against the destruction of the property to be received on exercise or conversion. • Anti-dilution: protecting the pro rata value of the property to be received on exercise or conversion.

  44. Protecting Options 8-44

  45. Protecting Options 8-45

  46. Protecting Options 8-46

  47. Protecting Options 8-47

  48. Protecting Options 8-48

  49. John Parkinson v. West End Street Railway Company8-49 • Highland Street Railway issued bonds. • Later, a statutory amendment of the charter authorizing a new issue of securities provided that the bondholders could convert their bonds into preferred stock as the bonds matured. • It subsequently consolidated with the Middlesex Street Railway, and later with West End Street Railway. • In each case the surviving corporation was made subject to “all the duties, restrictions and liabilities” of the predecessor corporation. • Is plaintiff entitled to preferred stock for his bonds? No.

  50. John Parkinson v. West End Street Railway Company8-50 • The option is “simply an option to take stock as the stock may turn out to be when the time for choice arrives.” - page 576. • If the issuing corporation goes out of existence before the conversion date, the conversion rights don’t stand in the way. • “The option gives him merely a spes (hope), not an undertaking that the corporation will continue for the purpose of making it good.” • The bondholder’s right is subject to the condition that the corporation shall not have vanished. - page 577. • Where a corporation isn’t contractually bound to preserve its existence for the option holders, it’s free to reorganize in a way that destroys the stock. • The consolidation didn’t keep the Highland Street Railway so far alive as to impose any duties on its successors with respect to the options.

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