Viney8e IRM ch20

Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 20
Options
Learning objective 1: Understand the structure and operation of option contracts, and describe
the types and component parts of option contracts available in the global markets
•

An option contract gives the option buyer the right, but not the obligation, to buy or sell a
specified asset at a predetermined price (the exercise price) at a specified date.

•

A call option gives the option buyer the right to buy an asset, while a put option gives the buyer
of the option the right to sell an asset.

•

A European-type option can only be exercised on the specified contract date, while an Americantype option can be exercised at any time up to the expiry date.

•

Because the buyer of an option contract has the right but not the obligation to conduct a
transaction, the writer (seller) of an option will charge the buyer a premium.

•

The premium is paid by the option buyer, to the option writer, at the start of the contract.

•

The buyer of an option has no obligation to exercise the option. Therefore, an option allows a
risk manager to protect the downside of a risk exposure while at the same time leaving open the
opportunity to gain from any positive price movements.

Learning objective 2: Explain the profit and loss payoff profiles of call option and put option
contracts and consider the requirements of covered option contracts
•

Profit and loss payoff profiles show the potential gains and losses that are available to both the
writer and the buyer of an option contract.

•

The writer of an option receives the premium at the start of the option contract.

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•

The writer of a call option retains the full premium so long as the current market price remains
below the exercise price. If the market price goes above the exercise price, the writer begins to
lose the premium. If the market price rises above the exercise price plus the premium (the breakeven price), the writer is in a loss position.

•

With a put option the writer retains the full premium so long as the current market price remains

above the exercise price. If the market price goes below the exercise price, the writer begins to
lose the premium. If the market price falls below the exercise price less the premium (the breakeven price), the writer is in a loss position.

•

A covered option is an option where the writer provides a guarantee that the writer can complete
the contract if the option is exercised. For example, an option is covered if the writer is holding
sufficient of the underlying asset, or is able to borrow the underlying asset before settlement
date. Exchange-traded options are covered options.

Learning objective 3: Describe the structure and organisation of the international and Australian
options markets, including examples of the types of option contracts available
•

Exchange-traded options are standardised contracts where the clearing house places itself
between the option buyer and the option seller through the process of novation.

•

Over-the-counter options may be non-standardised contracts negotiated between the buyer and
the seller (the seller usually being a commercial or investment bank).

•

An enormous range of option contracts is available on exchanges around the world; each
exchange tends to specialise in options on certain asset classes.

•

Exchange-traded option contracts available in the Australian market on ASX Trade and ASX

Trade 24 include options on futures contracts, share options on specified shares and share market
indices, low-exercise-price options over shares listed on the ASX (high premium, low exercise
price) and warrants.

•

An over-the-counter interest rate option may be a cap, a floor or a combination called a collar.

Learning objective 4: Identify and explain important factors that affect the price of an option
contract, including intrinsic value, time value, price volatility and interest rates
•

A range of variables affects the premium paid to buy an option.

•

The intrinsic value, being the relationship between the market price of the underlying asset and
the option exercise price, is a key variable.

•

The price of an option increases with the time to the expiration of the contract. Purely on the
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basis of probability, there is a greater chance that the option may be exercised if the option has a
long life.
•

Similarly, the more volatile the price of the underlying asset, the greater is the value of the

option, since there is an increased probability that the price of the asset may attain a level at
which it will be profitable to exercise the option.

•

Interest rates are another variable that affects the value of an option. Unlike the other variables,
the relationship between interest rates and the value of the option differs between call and put
options. In the case of a call option there is a positive relationship, while with a put option the
relationship is negative.

Learning objective 5: Develop options strategies that are appropriate to hedge price risk,
including single-option strategies and combined-option strategies, and discuss the advantages and
disadvantages of option contracts for the management of risk
•

There is a vast range of options strategies that may be adopted by hedgers and speculators.

•

The simplest are single-option strategies, including a long-asset and short-call strategy, and a
short-asset and long-call strategy.

•

More complex strategies involve the simultaneous purchase and/or sale of two or more option
types. Strategies include a vertical bull spread, a call bull spread, a vertical bear spread, a put
bear spread, a long straddle, a long strangle, a short straddle and a short strangle.

•

A barrier option may be a knock-out option that extinguishes if a specified nominated physical
market price is reached, or a knock-in option that is activated if a specified market price is
reached.

•

An option contract allows a hedger to cover the downside of a risk exposure, but still take
advantage of any possible upside in price movements.

•

In order to obtain this flexibility, the buyer of an option contract must pay a premium to the
writer of the contract.

•

Option contracts are particularly useful in volatile markets, but the premiums will be higher.

•

Complex option-based risk management strategies are available; however, a risk manager must
fully understand the risks being managed, the risk management products being used and the
implications of any new risks a strategy may create.

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Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a

particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. You have a friend who has heard about options and would like some more information
about them. Help him to understand the characteristics of both call options and put options.
Make sure you explain the relevant options markets terminology, including what is meant by
‘premium’, ‘strike price’ and ‘exercise price’. (LO 20.1)
•

Option contract—gives the buyer of the option the right, but not the obligation, to buy or sell a
specific asset on a specified date at a price determined today.

•

Call option—give the buyer of the option the right to buy under the terms of the option contract.

•

Put option—gives the option buyer the right to sell under the terms of the contract.

•

Premium—in order to receive the right to buy or sell (without the obligation), the buyer of the
option will pay a premium amount to the writer of the option. The premium represents the
maximum potential income the writer can earn for the commitment to the contract. Note: if the
price moves against the writer, they will begin to lose the premium. If this continues the writer
may potentially make a loss on the contract.

•

Exercise price—sometimes referred to as the strike price; the price specified in the option
contract at which the option buyer can buy or sell.

2. A company has a debt facility that will need to be refinanced in three months’ time. It is
concerned that interest rates may change in that time, but is uncertain whether they will rise
or fall. The company is considering using an option contract to manage the risk exposure.
What are the advantages and disadvantages of using an option contract strategy to manage an
interest rate risk exposure? In your answer, consider the nature of an option contract within
the context of exchange-traded option contracts and over-the-counter option contracts. (LO
20.1)
•

An options contract gives the buyer the right, but not the obligation, to buy or sell.

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•

If rates rise the option contract provides protection to the borrower, however, if interest rates fall,
the borrower is able to take advantage of the lower rate by not exercising the contract and
allowing the option to lapse.

•

The borrower needs to consider the opportunity costs and cash flow implications of an option
contract; that is, the premium will need to be paid up-front.

•

An exchange traded option contract is a standardized contract offered through a formal exchange
such as the ASX. In this case, the contact terms may not exactly match the risk exposure of the
company. If the contract is in-the-money then it is possible to sell the contract through the
exchange.

•

An over-the-counter contract is not standardized and therefore can be tailored to meet the
specific risk management needs of a risk manager. However, there is not a liquid market.

3. (a) Explain the differences between American-type options and European-type options.
•

An American [type] option is an option that can be exercised by the holder any time between its
origination and expiration.

•

A European [type] option gives the option buyer the right to buy or sell at the exercise price only
at a specified date or dates.

(b) What are the advantages of each option contract for both the buyer and the seller of a
contract?
•

The American type option is a much more flexible product; for example, the holder of an
American type option to buy Westpac Banking Corporation shares at $20.35 may exercise the
right to buy at any time during the life of the option, particularly if Westpac shares are trading in
the market above the $20.35 exercise price.

•

Exchange traded option contracts are often American type options.

•

The European type option is relatively cheaper in that a lower premium is payable; for example,
the buyer of a put option to sell BHP Billiton shares at $30.00 will hold the option to exercise
that right on the expiration date specified in the option contract.

•

This lower cost type of option may be attractive to risk managers who have a specific date
related risk to hedge.

(c) Discuss the effect of each option type on the pricing of the premium. (LO 20.1)

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•

The buyer of an American type of option will be required to pay a higher premium than would
otherwise be payable for the same European type option. The higher premium on the American
type option, or the lower premium on the European type option, reflects the relevant risk
relationships.

•

The writer of the American type option will be compensated for providing a much more flexible

risk management product.

4. Aurizon Holdings Limited (AZJ) shares currently trade at $5.21. An investor enters into a
long-call option on Aurizon with an exercise price of $5.80 per share in four months, and a
premium of $0.28 per share.
(a) Calculate the break-even price for the short call position.
•

The short call position is held by the writer of the option. The writer of the option receives the
$0.28 premium. The break-even for the writer is the exercise price plus the premium.

•

That is, $5.80 + $0.28 = $6.08

(b) Draw a fully labelled diagram of the long call and short call positions.

(a) Buyer of option
Profit

(b) Seller of option
Profit
Break-even

Break-even

+$0.28
Premium
0

$5.80
$6.08

Market
price

$6.08
$5.80

Premium
-$0.28

Loss

Exercise
price

Loss

6

Exercise
price


(c) At what minimum stock price will the option buyer exercise the option on the expiration
date? (LO 20.2)
•

The option buyer will exercise the option when the share price in the stock market is above $5.80

•

While the share price is between $5.80 and $6.08, the buyer will exercise the option in order to
recover some of the premium already paid.

5. Wesfarmers shares currently trade at $43.00. A funds manager is holding a large number of
Wesfarmers shares in an investment portfolio and wishes to protect the value of the
investment. The manager buys a long put option with an exercise price of $42.50 per share and
pays a premium of $1.30 per share.
(a) By entering into this options strategy, explain whether the fund manager will exercise the
option if the spot price is above or below the exercise price.
•

The fund manager has bought the right to sell Wesfarmers shares at $42.50

•

The manager will exercise the option if the share price is below the option exercise price of
$42.50

(b) Calculate the break-even price for the long put position.
•

The break-even point for the buyer of the option (long put) is the exercise price less the
premium; that is: $42.50 – $1.30 = $41.20

•

Note: the option holder will exercise the option when the share price is between $41.20 and

$42.50 as he/she will be able to offset the cost of at least part of the premium that has already
been paid. If the share price falls below $41.20 the option holder will be in-the-money.

(c) Draw a fully labelled diagram of the long put and the short put positions. (LO 20.2)

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(a) Buyer of option
Profit

(b) Seller of option
Profit

Break-even

Break-even

+$1.30
Premium
$41.20

0

$42.50

Market
price

$42.50

$41.20

Premium
-$1.30

Loss

Exercise
price

Loss

Exercise
price

6. A speculator has written an option on the shares of Sonic Healthcare.
(a) Discuss the differences between a covered option and a naked option.
•

A covered option is one where the writer or seller holds the underlying shares or asset. A naked
option is one where the writer does not hold the underlying asset.

•

A writer of a naked option is required to pay a margin. The option writer will usually be liable
for daily margin payments while the contract is open.

•

Writing naked options can be particularly risky. For example, the writer of a call option faces

potentially unlimited losses if the price of the underlying security increases. If, for example,
Sonic Healthcare traded at $17.00 per share, a naked call writer would begin to suffer losses as
the share price increases. Obviously, an unexpected positive announcement that increased the
share price significantly could be disastrous for the call writer.

(b) What requirements will be applied by an options exchange to ensure that the option writer
can meet the contract obligations? (LO 20.2)
•

The potential loss that may be incurred by the writer of an option contract could extend well
beyond the amount of the premium received.

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•

An option is covered when there is a guarantee that the writer of the option can complete the
contract.

•

The writer of a call option would be considered to have written a covered call option if the writer
owned sufficient of the underlying asset to meet the requirements of the option contract in the
event that it is exercised; for example, if the call option gave the right to the option-holder to buy
shares in Sonic Healthcare, the option would be covered if the writer held enough of those shares
to meet the requirements under the option.

•

Under an alternative arrangement, an option-writer would be covered if a third party, such as a
securities custodian, provided a guarantee that the option-writer could borrow the underlying
security on or before the options contract settlement date.

7. (a) Options exchanges tend to specialise in certain option contracts. Discuss this statement
within the context of the international options markets.
•

Globalisation of the financial markets, coupled with the use of electronic communication and
product delivery systems means that options trading can take place 24-hours a day around the
globe. The tyranny of distance is no longer a constraint on trading.

•

Price with the markets is directly influenced by the level of liquidity in the market. Highly liquid
markets tend to have lower costs and tighter margins, and therefore become more competitive.

•

Exchanges now tend to specialise in options products in which they have strength and liquidity

•

The strong options contracts are typically based on underlying local physical market
commodities and financial instruments; for example, in Australia options contracts offered by the
ASX are based on shares listed on the Australian exchange.

(b) Option contracts may be traded by open outcry or through electronic trading systems.
Briefly explain each of these methods used for trading option contracts. (LO 20.3)
•

Open outcry occurs on the floor of the exchange. Clients will contact their brokers who will
forward the orders directly to traders on the floor of the exchange. The trader will use a
combination of voice and hand-signals to try and execute the order with another trader on the
floor. To an observer, floor trading looks very colourful and noisy, but it may be argued that it is
less efficient than electronic trading.

•

The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) are both
open outcry exchanges.

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•

Electronic trading uses sophisticated communication and computer-based trading and settlement
systems. Clients contact their broker who enters the order directly into the exchange’s electronic
trading system. The system automatically matches buy and sell orders and provides the
information to the clearing-house.

•

The clearing-house uses its settlement system to accept margin calls, record contracts and
facilitate delivery as required.

•

The Australian Stock Exchange (ASX), including the Sydney Futures Exchange (SFE) is an

example of an electronic exchange.

•

Electronic systems would appear to be more efficient in the conduct of trades and also allow
price information to be more quickly provided to the market.

8. One of the categories of options available to investors and speculators is LEPOs. Assuming 7
per cent margin, what would be the percentage return and dollar profit to an investor who
purchased one LEPO (for 1000 shares) for a premium of $26 220 and later closed out the
position when the LEPO premium was $28 430? (LO 20.3)
•

A LEPO premium of $26 220 indicates a LEPO price of $26.22 for this company. Just like any
other derivative, the LEPO price will reflect changes underlying share price.

•

The LEPO buyer must pay, in this case, 7 per cent margin. Hence, the buyer would have to pay
$1835.40.

•

The buyer closes out the position at a LEPO price of $28.43 per share or a LEPO premium of
$28 430.

•

The total profit is worked out on the basis of the initial margin. The investor paid $1835.40 in an
initial margin outlay. The LEPO position has increased in value by $2210 (28 430 – $26 220).

•

The dollar profit is therefore $2210.

•

The percentage return is 120 per cent ($2210/$1835.40).

9. Discuss the relationship between the exercise price of an option, the current market price of
the underlying asset and the intrinsic value of the option. In your answer explain the money
position of an option. (LO 20.4)
•

The relationship between the current market price of the underlying asset and the exercise price
of an option determines whether or not the option actually has a value if the option was exercised
immediately. This value is referred to as the intrinsic value of the option.

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•

If an option could be exercised immediately and a profit made, the price that would be paid to
buy such an option should be equal to the intrinsic value of the option.

•

The greater the intrinsic value of the option, the higher is the value of the option, that is, the
larger the premium.

•

The relationship between the price of an asset and the option exercise price determines whether
an option is in-the-money or not. An option is in-the-money if it can be exercised at a profit, that
is, if it has a positive intrinsic value.

•

If the exercise price is equal to the price of the asset in the physical market, the option is said to
be at-the-money.

•

In the situation where an option would not be exercised, the option is described as being out-ofthe-money.

10. During periods of market distress, investors’ risk aversion increases and implied volatility
in the options markets moves higher to reflect declines in the physical markets and the
increased uncertainty confronting investors (when people are more risk averse, they will pay
more to protect or hedge their portfolios). Develop a basic trading strategy for a speculator
who believes that risk aversion will soon abate. (LO 20.4)
•

This situation is a favourite among hedge funds but it involves particular risks that must be
monitored carefully.

•

A number of trading strategies might be designed. However, the simplest is to take a position that
will profit as risk aversion and implied volatility decline or return to normal levels.

•

The simplest trading strategy is to write pairs of options, puts and calls. As implied volatility
declines, the options premiums should also decline (it will be recalled that volatility is one of the
determining factors of options prices) and the options writer can reverse positions at lower
premiums and collect the differential.

•

A strategy of writing options under these circumstances is called ‘shorting the vol’ (vol being
short for volatility). The options writer is, in this case, akin to an insurance provider. Investors
are extremely worried about further volatility and are willing to pay to insure their portfolios (by
purchasing options). The options writer must judge whether the insurance premiums, the options
prices, are sufficiently high to justify the risk that volatility might increase further. If so, the
options writer provides the insurance by writing options and collects when the insured disaster
fails to materialise.

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•

The options writer bears the risk that markets may become more volatile. This type of trade was
at the centre of Long Term Capital Management’s (LTCM) collapse in the late 1990s.

11. A company knows that it will need to borrow $500 000 in six months’ time and is concerned
that interest rates may rise before that date. The company wishes to protect itself against a rise
in interest rates and decides to use an options collar strategy. Explain how a collar strategy is
structured and why the company might consider this type of strategy. (LO 20.5)

•

A collar is an interest rate risk management strategy using a combination of an options cap and
an options floor. Caps, floors and collars are over-the-counter options that are negotiated
between a financial intermediary and a borrower. A cap is a strategy that may be adopted by a
company that wishes to place an upper limit on the interest rate payable on a future borrowing
commitment.

•

The borrower would pay a premium to buy the cap.

•

At the same time, the company may sell an option contract that places a minimum limit, or floor,
on how low the interest rate payable may fall. The borrower would receive the premium for
writing the floor.

•

The combination of a cap and floor is called a collar. This strategy is designed to lower the
overall cost of the cover; the premium paid for the cap is offset by the premium received for the
floor.

•

The success of this strategy will depend upon the forecast direction and volatility of future
interest rates; for example, if interest rates in the market are generally expected to rise over the
contract period, the cost of the cap premium will be higher than the premium received from the
sale of the floor, therefore, the premium offset of a cap and a floor of the same contract period

will not usually be equal.

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Borrowing hedge collar option strategy
Cost of
borrowing
8.00%

Interest rate cap – pay option premium

Collar

7.00%

Interest rate floor – receive option premium

12. An investor has a quite bullish view that prices in the share market will rise, but is
concerned that there is still some risk that prices might fall. Draw and explain the relevant
profit profiles for a call bull spread strategy for (a) the holder of a call option, (b) the writer of
a call option, and (c) the long call plus short call. (LO 20.5)
•

The investor will position the option strategy so that if the asset price rises a profit would be
made, but at the same time, they gain some protection in the low probability situation that prices
might fall. One way of achieving this would be to simultaneously buy and sell call options.

•

The purchase of the call option provides the potential profit if the share market rises.

•

The premium paid on the purchase of the call option may be high since there is an expectation
that the market will rise.

•

One way of recouping some of the cost of the option would be to simultaneously write a call
option and thus earn a premium.

•

The short call would be written at an exercise price higher than that for the long call option.

•

The profit profile for the combined short put and long call strategy follows.

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Strategy—Call bull spread: quite bullish, with some risk of a price fall
Profit

(a) Holder of a call option
Exercise price

Market price

Premium

Loss

(b) Writer of a call option
Profit
Exercise price

Premium

Market price

Loss

(c) Long call + short call
Profit
Price
expectations

Market price
Net
Premium

Loss

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13. (a) In what circumstances might an investor consider a vertical bear spread option

strategy?
•

When there is a strong expectation that asset prices will fall; for example, a confident
forecast that the share market will experience a downturn.

(b) Discuss the construction of the strategy and draw the relevant profit profiles. (LO 20.5)
•

The first part of this combination options strategy is to buy a put option; pay a premium
and simultaneously write a call option with an exercise price higher than that for the long
put: a premium is earned.

•

The advantage from writing the short call is that the premium would go some way
towards reducing the cost of acquiring the long put.

•

At the same time, the writing of the call exposes the writer to potentially unlimited losses
if the price of the asset unexpectedly rises.
Strategy—very bearish about asset price (vertical bear spread):
Profit

Holder of a put option
Exercise price

Market price

Premium

Loss

Profit

Writer of a call option

Exercise price
Premium

Market price

15


Loss

Profit

Long put + short call
Price expectations

Market price
Net
premium

Loss

•

In a situation where the on-balance expectation is bearish, but there is considered to be a
reasonable risk that the asset price may rise, the vertical bear spread would not be
favoured.

14. There is an expectation of increasing price volatility in the market due to the uncertainty
surrounding the winding back of the stimulus programs and expansionary monetary policies
that were put in place during and after the GFC. Design an options strategy that will enable a
profit to be locked in, regardless of the future direction of asset prices. (LO 20.5)
•

Situations may arise when the price of the asset is expected to become more volatile, but without
an obvious trend emerging.

•

What is needed is a combination strategy that will allow a profit to be made regardless of
whether the asset price rises or falls.

•

To profit from a price rise, a call option would be bought; to profit from a price fall, a put option
would be bought. The simultaneous purchase of a long call and a long put, with a common
exercise price, is referred to as a long straddle.

Expectation of increased price volatility: long straddle
Profit

Holder of a call option

Exercise price

Market price
Premium

16


Loss

Profit

Holder of a put option

Exercise price
Market price
Premium

Loss

Profit

Long call + long put
Price expectations

Market price
Net (double)
premium

Loss

•

If the net ‘double’ premium is considered to be too expensive, a variation on the long straddle
may be put in place.

•

Rather than buying the call and put options with an identical exercise price, the two options
could be purchased with out-of-the-money exercise prices.

•

This strategy is referred to as a long strangle.

•

The long strangle would be particularly appropriate when the expectations of increased volatility,
without trend, are tempered by a view that the asset price may continue to stagnate for some time
around price A. If the price does stagnate, the loss sustained by the individual would be the
double premium. This is clearly less for the long strangle than it is for the long straddle.

Expectation of increased price volatility: long strangle
Profit

Holder of a call option

17

Exercise price

A
Market price
Premium

Loss

Profit

Holder of a put option

Exercise price

Market price
Premium

Loss
Profit

Long put + long put
Price expectations

A
Market price

Net (double)
premium

Loss

15. A corporate treasurer is concerned at the high cost of the premium associated with
establishing an options strategy. The company’s bank suggests that the use of a barrier knockout option to protect against a rise in the spot exchange rate might be a cheaper alternative
strategy.
(a) Explain how a barrier knock-out option is structured.
•

The barrier option is suited to the management of foreign exchange risk exposures and includes
both knock-out and knock-in options.

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•

The knock-out option is extinguished if a specified spot exchange rate barrier is breached. The
barrier rate can be set above or below the current spot rate. Because the barrier limits the
exposure of the option writer the premium is not as high as with a straight option.

•

The knock-out nature of the barrier option is shown in the following figure. In the figure, while
the specified spot exchange rate remains below the barrier rate the option remains in existence.

•

If the spot exchange rate moves above the barrier rate before the expiration date, the option
ceases to exist.

(b) Draw a fully labelled diagram showing the strategy.

Barrier option—FX knock-out option
Spot FX rate

Barrier rate
Knock-out trigger point
Time

(c) Using what you know about barrier knock-out options, briefly explain how these
securities might contribute to the volatility of market prices. (LO 20.5)
•

Simply, barrier knock-out and knock-in options might encourage traders to attempt to
knock-out particular options by pushing prices through particular critical levels.

FINANCIAL NEWS CASE STUDY
One of the classical parts of economic theory is agency theory. The subject matter mainly
concerns the principal–agent problem and studies ways in which this may be overcome. In
finance, the study of agency problems draws on work by Michael Jensen.

The shareholders of a firm, and their representatives on the board of directors, face an ‘agency
19


problem’. The CEO and other executives that they have appointed to run the firm may have
interests that conflict with the interests of shareholders. Executives may also have different
preferences for risk that result in them taking more or less risk than the shareholders desire. The
implications are significant. If a CEO adopts a high risk strategy and always, for example,
chooses more risky projects over less risky ones, the free cash flow that is generated by the
company and, consequently, the share price may be much more volatile than the shareholders
are comfortable with. The more the volatile the share price, the more risky the firm is from the

point of view of the shareholders.

The challenge is to align the interests of the CEO and executives with the interests of the
shareholders. One way to do this is to ensure that the executives have a stake in the company,
either through stock ownership or through the granting of stock options that derive their value
from the underlying share price. Despite debates concerning the possibility that stock options
may enhance an executive’s preference for risk, stock options became a staple of managerial
compensation and remained so for many years. In the USA, this has changed very quickly. In
August 2013, The Wall Street Journal carried the following editorial about the potential
extinction of stock options as a form of compensation:

At their peak in 1999, stock options accounted for about 78% of the average executive’s longterm incentive packages. In 2012, they represented just 31%, and are expected to shrink to 25%
in 2015, based on grant values in 2013, according to an analysis of the 200 largest U.S. public
companies by compensation consulting firm James F. Reda & Associates.

Companies are rapidly replacing those grants with restricted stock, which offers a more
'certain' return to employees, he says. Stock options give employees the right to buy a
company’s stock at a specified 'strike price' at a predetermined date in the future, but they are
worthless if the stock doesn’t reach that price. Restricted shares, on the other hand, give an
employee the full value of a company’s stock, at a future date, or when a performance goal is
reached.

We have discussed equity options throughout this chapter and you understand some of their
properties. When included as part of a manager’s compensation package, options may have
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little immediate value if the strike price is well above the current share price. Restricted shares
or stock, on the other hand, have current market value. If a manager is awarded 1000 shares in
the company when the share price is $20, the value is $20 000, even if the manager cannot

access the shares for a period of time (because they are restricted pending the achievement of
some performance indicator).

Some of the advantages of restricted shares or stock are quite obvious. Most importantly, the
compensation is transparent and easy to understand. The number of shares received multiplied
by the current share price represents the value of the compensation. Secondly, it may be the
case that restricted stock promotes a greater sense of ownership. Unlike options that may be
viewed as an added bonus with no immediate value or relevance, restricted stock does represent
ownership or potential ownership in the company. Thirdly, restricted stock may have indirect
benefits for investors who desire higher dividend payouts. Many companies in the USA have
very high reserves of cash. One use of cash is dividends. Restricted stock provides an incentive
for higher dividend payouts because the executives who hold restricted stock also receive that
dividend (even on the restricted part). This incentive does not exist when compensation is
predominantly options based.
SOURCE: Extract from Emily Chasan, 2013, ‘Last Gasp for Stock Options?’, CFO Journal, The Wall Street Journal, 26 August 2013,
accessed 1 August 2014.

DISCUSSION POINTS
• Using what you know about the relationship between share price volatility and the
value of equity options, explain why compensating a manager with equity options may
be thought to lead to the company becoming riskier?
Stock options increase in value as the volatility of the share price increases. A manager who
is compensated with options may have some incentive to increase the riskiness of the
projects that the company selects.
• One of the reasons given by The Wall Street Journal for the decline in stock optionsbased compensation is that many executives’ and other employees’ options became
worthless following the GFC. Do you think that as the crisis becomes a more distant
memory, executives will start to demand a return to options-based compensation?
There is no right or wrong answer here. Managers who did not experience the GFC and the
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decline in the value of managerial compensation that was associated with it may come to
demand options-based compensation in the future.
• Compare options-based compensation schemes with restricted share or stock grants.
Which scheme do you think is more likely to align the interests of shareholders and
executives? How does restricted stock compare to equity options if the shareholders
desire management to take more risk in managing the company?
There are arguments for and against each type of compensation scheme. Most importantly,
restricted stock or stock grants represent a tangible ownership stake in the company. This is
quite different from stock options that merely represent the right to obtain such a stake.

It is possible to argue that stock options may be more likely to encourage risk-taking.
Because the options only have a value if the stock price rises by a certain amount, it is
possible that options may encourage managers to embark upon riskier projects. Riskier
projects increase the volatility of the share price and increase the probability that the strike
price on the manager’s options will be exceeded (and the options end up ‘in the money’).

True/False questions
1.

T Option contracts protect a hedger against potential losses while still allowing the hedger to

make a profit from favourable price movements.
2.

T A put option gives the buyer of the option the right to sell the specified asset at the

predetermined exercise price.
3.

T The strike price is the price at which an option can be exercised by the option buyer at a

future date.
4.

F An American-type option may not be exercised by the holder of the option at any time up

to, and including, the expiry date.
5.

T A collar is an options strategy that combines the simultaneous buying and selling of a cap

and a floor in order to minimise the net cost of an interest rate risk cover.
6.

T The long-call party to a call option with an exercise price of $2.00 and a premium of $0.50,

where the current price of the underlying asset is $2.20 on the exercise date, would make a loss of
$0.30.
7.

T A long-call party would not exercise a call option with an exercise price of $4.00 and a

premium of $1.00 if the current price of the underlying asset is $2.90 on the exercise date.

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8.

F A put option buyer will exercise the option with an exercise price of $10.00 and a premium

of $1.50 if the current price of the underlying physical market asset is $11.30 on the exercise date.
9.

F The seller of a put option will make a profit of $0.20 if an option has an exercise price of

$10.00 and a premium of $1.50 and the current price of the underlying physical market asset is
$11.30 on the exercise date.
10.

F One of the advantages for both buyers and sellers of options is that, while the potential

losses are limited, the potential profits are unlimited.
11.

T The writer of a call option on a particular asset is said to have written a covered option if

the writer owns sufficient of the underlying asset to meet the requirements of the option contract
should it be exercised.
12.

F LEPO options do not require any margin from either the buyer or seller.

13.

F A LEPO is a deliverable European-type option normally based on a parcel of 100 shares

listed on the ASX.
14.

F An in-the-money option is one where the exercise price is equal to the current price of the

underlying asset in the physical market.
15.

T All other relevant variables being constant, the longer the time to the expiration of an

option, the greater the value of the option.
16.

T All other relevant variables being constant, the greater the price volatility of the underlying

asset, the more valuable is an option.
17.

F There is a positive relationship between the value of a put option and the rate of interest, all

other relevant variables being constant.
18.

T If you are to acquire an asset in the future, and you expect the asset price to rise, the

purchase of a call option would provide some protection against the expected price rise.
19.

F One way of profiting from an expected fall in the price of an asset that you own is to write

a put option on the asset.
20.

T Speculators who believe that the price of an asset is going to become highly volatile in the

near future could position themselves to profit from a price rise, or fall, by simultaneously buying a
call option and a put option on the asset.

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