GROUP B

CONSULTING
 About Our Case
2

Larry Steffen Valuing Stock Options in a Compensation Package

Study
It was interesting that most new hires
preferred the cash bonus, but Steffen
wondered if the stock options were
actually the superior alternative

Larry Steffen a recent graduate, has been offered a job at Athena
Global Technology (“Athena”), however has to select between two
compensation packages, a base salary plus a cash bonus or the same
base salary plus employee stock options.
The cash bonus consists of $20,000 one time payment paid at the
start of the employment with no additional terms and conditions.
The employee stock option provides Larry the right to purchase 5000
Athena shares anytime between t=5 and t=10, conditional on Larry
being an employee till this time.
Complications due to the changing interest rate, taxation policies and
exercise time require a non-standard approach to value both
compensation options and select the more convenient one.
 Road Map
3

Steps for success

START ANALYSE

SIMULAT QUESTIONS
DESIGN MODEL
E

RESEARC
H
Information from Case Study
4

Focus points

Share Price
The strike price on 29th May 2013 was $22.71

Strike/Exercise Price
The price at which the call option is exercised is
the same as the current share price, $22.71

Interest Rate Term Structure

Interest rates are not constant over time, the
yields of various treasury bonds are provided

Timeline
Larry has the choice to exercise the option
anytime between t=5 and t=10.
 Yield Curve
5

Yield Curve of Treasury Bonds

2.50%

2.00%
f(x) = − 0 x³ + 0 x² + 0 x + 0
R² = 1 Cubic
Interpolation
A cubic curve was used to
1.50% determine the yield curve
for time periods which were
Spot Rate

not provided by the treasury

bonds.
1.00%
A R2 value of 0.9997
indicates an extremely good
0.50% fit to the empirical data.

This will be used for the

remainder of the
0.00% presentation.
0 20 40 60 80 100 120 140
Month
 Stock Price
6

Monthly stock prices of Athena

$35

$30
Monthly
$25 Increments
Based on trend of previous
stock prices, stock prices are
$20
likely to increase.

$15

$10

$5

$0
Annualised Standard Deviation
7

Volatility of daily stock returns

35%

30%
Past 3 Months
Provided information used the
25%
daily stock returns of the past 3
months to determine the
20% volatility.

15%
Limited to
10%
Technical Analysis
Past performance/volatility is
not indicative of future volatility.
5%

0%
 Measuring Volatility
8

Best measure of volatility

6 Months
6 Months

t y Fu
ili
l at tu
re
Vo Vo
s t 3 Months
3 Months la
Pa ti
li t
y

Past Future

1 Year
1 Year

9 Months
9 Months
 Implied Volatility
9

𝜎
 

 Implied Volatility is a procedure to determine

the market expectation of directly using the
market prices for available securities.

Since there is a particular market estimate of the

underlying volatility implicit in the option price
we can speculate on future volatility by trading
the option.

This method is superior to technical analysis

alone as it has the potential to incorporate all
currently available public information and is not
limited to only past returns.
 Black Scholes
10

 
Model
The Black Scholes Model is a method to determine the value of
a European Option based on a various of input variables including:

- Stock Price (S0)

- Strike Price (X)
- Time to Expiration (t)
- Continuous Risk Free Rate of Return (r)
- Volatility (σ)

This method is fast to compute and determines solutions very

accurately.
 Black Scholes
11

Assumptions
No Dividends Short Selling and Immediate Delivery
The underlying stock provides no dividends or other Short selling is permitted, and the short seller will receive
distributions during the life of the option. immediately the full cash proceeds

No Transaction Exercise only on Expiration Date

There are no transaction costs for buying or Costs
selling either The call option can be exercised only on its expiration
the stock or the option. date.

Constant Interest Rate Continuous Trading

The short-term, risk-free interest rate is known and is Trading in all securities takes place continuously, and
constant during the life of the option. the stock price moves randomly.

Fractional Purchase
Any purchaser of a security may borrow any fraction of the
purchase price at the short-term, risk-free interest rate.
Calculating Implied Volatility
12

Examples of the Call Options Available

$22 $22 $22 $22

$1.0 $1.5 $2.4 $3.8

7 5 7 0
Call Call Call Call
Option Option Option Option

22 June 2013 17 August 2013 18 January 2014 17 January 2015

Strike Price: $22.71 Strike Price: $22.71 Strike Price: $22.71 Strike Price: $22.71

24 Days 80 Days 234 Days 598 Days

 Calculating Implied Volatility
13

    $22

$3.8
0
Call
Option

17 January 2015

Strike Price: $22.71

𝜎 ≈ 30 %
 

598 Days

  , from cubic interpolation

Type of Option 14

“The options will not be vested until

you have been with Athena for five
years; you could exercise your stock
options and purchase the 5,000
shares any time after your fifth
anniversary with the company, but
they must be exercised before you
tenth anniversary.”
 American or 15

European
European?
A European option can only be exercised at the expiration
date. Since Larry can exercise the option any time
between t = 5 and t = 10, the option is not an European
option

American?
An American option can be exercised anytime prior to the
expiration date. Since Larry can not exercise the option
before t = 5, the option is not an American option.
 World Map
16

The solution lies between America and Europe

AMERICAN OPTIONS BERMUDAN OPTIONS EUROPEAN OPTIONS

 Bermudan Option
17

Bermudan

A solution in between

A Bermudan option is an option where the buyer has the right to exercise at a set (always discretely
spaced) number of times. This is intermediate between a European option—which allows exercise at
a single time, namely expiry—and an American option, which allows exercise at any time (the name
is jocular: Bermuda, a British overseas territory, is somewhat American and somewhat European—in
terms of both option style and physical location—but is nearer to American in terms of both)
Comparison of Option Valuation
18

Methods
One Step Binomial Multi Step Binomial Black-Scholes Monte Carlo

European

American

Bermudan

Varying Interest Rates

Closed Solution

Valuation Time
 Black Scholes
19

Inputs Model
Calculation
•  Call Option  
• Stock Price : $22.71 0.696505628
• Strike Price X: $22.71
• Interest Rate r: 0.02108
0.25217767
• Maturity T: 10
• Volatility : 0.30

Price of Call Option

 
 Binomial pricing
20

model Why is this used for this option?

The Binomial options pricing model approach is widely used since it is able
to handle a variety of conditions for which other models cannot easily be
applied.

This is largely because the model is based on the description of an

underlying instrument over a period of time rather than a single point.

As a consequence, it is used to value American options that are exercisable

at any time in a given interval as well as Bermudan options that are
exercisable at specific instances of time.
 Assumptions of the model 21

Assumptions

First Third
The model traces the
The rate of interest (r)
evolution of the
is constant throughout
option's key variables
the life of the option
in discrete-time. Second Fifth
There are only two Fourth Investors are risk
Markets are neutral i.e. investors
possible prices for the
frictionless i.e. there are indifferent towards
underlying asset in the
are no taxes and no risk
next period.
transaction cost
Binomial Input Variables 22

Binomial pricing using ten time - steps i.e. 1 per year

Stock Price S0=$22.71

Exercise Price K=$22.71

Volatility σ=0.30

Risk-free interest rate r=0.02108

Binomial Input Variables 23

Binomial pricing using ten time - steps i.e. 1 per year

Time to Expiration T=10

Number of periods n=10

Time per period dt=T/n= 1

 Risk Free Probabilities 24

 Up-state factor
u=) = 1.35

 Down-state factor
d= = 0.74

 Probability
Probability of up-state p = = 0.46
Probability of down-state 1–p = 1 – 0.46
= 0.54
Binomial Pricing Model 25

States of the world

Valuation is performed iteratively, starting at each of the final nodes (those

that may be reached at the time of expiration), and then working backwards
through the tree towards the first node (valuation date)

Firstly, we calculated whether the option was in-the-money from t = 10 for

all states of the world. The call options value at that time is the maximum
between it’s intrinsic value (S – K) or 0.

Then, the option was divided into two parts:

From t = 0 to t = 5, it was priced like a European call
From t = 5 onwards, it was priced like an American call
 Expected Value
Working backwards

The value of the call option for any state of the world can be seen as the expected value of the option itself
in one period - discounted back one period by the risk-free rate. Thus, we have

Let C(i, j) denote the value of the call options in a state of the world where there has been with h up-
movements and k down-movements

C(i, j) = e-r*dt x [p*C(i+1, j) + (1 – p)*C(i, j+1)]

 European vs American
The difference in valuation

An American option can be exercised anytime prior to the expiration

date whereas a European option cannot do so (only able to exercise
at the expiration). As such, in our calculations for American options,
we must account for the value of early exercise (S – K). If it is higher
than the discounted expected value, we would exercise at that point
in time.

American:
C(i, j) = Max(Discounted Expected Value, Value of Early Exercise)

European:
C(i, j) = Discounted Expected Value

To account for this – we use the Binomial option pricing model

 28

Expectations

EUROPEAN BERMUDAN AMERICAN

Since offered As it is an Since it

the least intermediary offered the
flexibility, it between the most
was assumed American and flexibility, it
to have the European, it was assumed
lowest price was assumed to have the
out of all to have a highest price
three price of all three
between the
two
However, they all had the same
price $9.64
 30

Why is that the

Put-call parity

case?
Recall the Put-call parity for stocks with no dividends

Ct − Pt = St − Kt*exp[-r(T - t)]

This means that

Ct - P t > S t – K t

Rearranging gives us

Ct > (St - Kt) + Pt

This means that the early exercise is never worth more than the value of the call option at anytime as the value of
put option is always greater than 0. Thus, discounted expected value is always greater than the value of early
exercise - effectively making the American option equivalent to a European one.
 Conclusion 31

“For a non-dividend paying

stock, an American call option
has the same value as an
European call option.

The value of early exercise will

never be greater than the
discounted expected future
payoff of the option.”
 32

Prices
What happens when the number of time steps (n) increases?

n = 20
n = 10 n = 30

$ 9.64
per option
$ 9.73 per option
$ 9.76
per option

u = 1.35 u = 1.24 u = 1.19

d = 0.74 d = 0.81 d = 0.84
p = 0.46 p = 0.47 p = 0.48
 33

Convergence to Black Scholes

What happens when n becomes really big?

Similar assumptions underpin both the Binomial model and the Black–Scholes model

The binomial model assumes that movements in the price follow a binomial distribution - and for
many trials, this binomial distribution approaches the lognormal distribution assumed by Black–
Scholes. Essentially, the binomial model provides a discrete time approximation to the continuous
process underlying the Black–Scholes model.
As such, for options without dividends, the binomial model value converges on the Black–Scholes
formula value as the number of time steps increases.
Comparison of Option Valuation
Methods
Black Scholes
In a European call option, it can
only be exercised at t=10.
The ability to not exercise in
earlier periods should decrease
the value compared to the ESO.
Gives an approximate idea,
however does not consider the
implications of taxation policies
34
Monte Carlo Binomial
In an American call option, it can
be exercised anytime between
t=0 and t=10
The increased flexibility to
exercise the option would result
in a higher value compared to
the ESO.
 Three Steps for
35

Running a successful Monte Carlo

Monte Carlo

Determine Run
Develop Model
Conditions Simulations

Step 1 Step 2 Step 3

 Determine Conditions and
36

Assumptions
Fluctuating Stock Price
Stock price follows a random path, however uses the volatility to
determine the increment, size of the jumps

Interest Term Structure

The interest rate is not constant. The term structure uses the provided
points and uses a cubic interpolation to determine the rates between.

Flexible Exercise Timings

Allowed to exercise at any time when expected cash flow will be positive.
Although there is no closed solution, a

Taxation Considerations
Our model makes the assumption that Larry will sell his shares one year
after exercising the option. This is to take advantage of a reduced
marginal tax rate and decrease Larry’s exposure to stock price volatility.
 Develop the Model
37

MATLAB
R2016a
MATLAB was chosen based
on the ability to handle a
large volume of data.

Variety of
Toolboxes
Improve the speed and
efficiency of running a
Monte Carlo simulation

Alternative Available
Possible to use an alternative
software to yield similar result.
Diagrammatic Representation
Diagrammatic Representation
Diagrammatic Representation

6.324
Diagrammatic Representation

6.324
Diagrammatic Representation

6.324
Diagrammatic Representation

6.324
Diagrammatic Representation

6.324
Diagrammatic Representation
45

ATHENA Determine Expected Value

T=0 Exercise date is distributed uniformly.
Stock price growth rates are distributed log-normally.
Yield curve are used to calculate discount rates.

T=5 T=10
.
Diagrammatic Representation
46

ATHENA Determine Expected Value

T=0 Exercise date is distributed uniformly.
Stock price growth rates are distributed log-normally.
Yield curve are used to calculate discount rates.

T=5 T=10
.
Diagrammatic Representation
47

ATHENA Determine Expected Value

T=0 Exercise date is distributed uniformly.
Stock price growth rates are distributed log-normally.
Yield curve are used to calculate discount rates.

T=5 T=10
.

x20,000 times
 Run Simulations
48

Stock Price
Taxation

Interest Rates

Exercise Flexibility
x20,000 times

$9.64-$9.77
 Income Tax

In 2013, the US Income Tax Rates

are calculated as below:
 Income Tax

In 2013 and
afterwards, the
long-term capital
gains of the US
government are
as following:
Diagrammatic Representation
51

ATHENA Exercise
T=0

T=5 T=10
.
Diagrammatic Representation
52

ATHENA Exercise
T=0

T=5 T=10
.
Diagrammatic Representation
53

ATHENA Exercise
T=0

T=5 T=10
.

Sell After 1 Year

Diagrammatic Representation
54

ATHENA Exercise
T=0

T=5 T=10
.

Sell After 1 Year

Account for Taxation (Reduced
Payoff)
Diagrammatic Representation
55

ATHENA Exercise
T=0

T=5 T=10
.

Sell After 1 Year

Account for Taxation (Reduced
Payoff)

x20,000 times
 Run Simulations
56

Stock Price
Taxation

Interest Rates

Exercise Flexibility
x20,000 times

$7.87-$8.01
 Early Exit / Lapse
57

Higher Payout of Stock is Conditional

The higher payout of the stock option is conditional on Larry staying in
the company for 5 years. If there is any chance of early exit, then the
payout is 0.

Reasons for Exit outside Technical Analysis

Technical and fundamental analysis is used to determine insights for
investors, and has very limited scope for determining the employment
period of employees.

Probability of Exit can Fluctuate

If Larry accepts the stock option, the probability that Larry will remain in
the company will be influenced by the fact that he will not be able to
exercise his options.
 Early Exit / Lapse
58

Assume the Probability of Exit Is Constant

This is done to simplify the model, the process can be adjusted to allow
for varying probabilities of early exit.
Average

$7.94
Relative vs Absolute
Aim is NOT to determine an absolute and exact valuation for the
employee stock option but rather to compare it with the alternative cash
option.
 Early Exit / Lapse
59

ected Present Value of Employee Stock Option for 5000 shares after tax [Conditional]
𝔼 [ 𝑋 ] =$ 7.94 ×5000=$ 39,700
 

Present Value of Cash Option After Tax

 
 Early Exit / Lapse
60

pected Value of Employee Stock Option After Considering Early Exit Probabilities
  5
𝔼 [ 𝑋 ] =39700 ∏ (1− 𝑝𝑘 )
𝑘=1
The probability of exit in the kth year
is pk
xpected Value of Employee Stock Option Assuming Constant Probability
𝔼 [ 𝑋 ] =3970 0(1 − 𝑝)5
 
 Early Exit / Lapse
61

Equating Both Options

 
p

0.1836
 Conclusion
62

Larry should pick Stock Option if p < 18.36%

p represents the probability of leaving in any of the first five years

Utility is dependent on Larry’s risk preferences

Even if the probability of early exit is less than 18.36%, depending on
Larry’s utility and risk averseness, he might still prefer the cash option
with a lower variance compared to the stock option with a higher
variance.