The Stock Options: Are They Worth What Their Price?

The Stock Options: Are they worth what their price?

Oscar Carbonell1, (ocarbonell@ipade.mx), IPADE Business School, México City, México

Abstract

The Stock Options have become one of the most commonly used instruments in the executives´ compensation packages. Nevertheless, the cost to the firm of the Stock Options, usually, is much higher than its value to the executives. One of the reasons for this discrepancy is that there is no secondary market for Stock Options, which, means that it is forbidden to sell them- and additionally, the majority of the executives lack the possibility of forming a portfolio with the same payoffs and sell it. Therefore, it prevents the executives from doing arbitrage and their expectations about the evolution of the stock’s prices are relevant, which in turn in the eyes of the executives further lowers the value of the Stock Option. We have developed a very simple model, in which on one side we have calculated the cost of the options to the firm by utilizing traditional formulas and on the other side we have worked with the formula Binomial but it includes a Certainty Equivalent Wealth function. We find that- depending on degree of risk aversion, the value of the option perceived by the executive is much lower than the cost that the firm bears for the same option. The differences between Stock Options and traditional options The Stock Options are calls based on the stock of the issuing firm to include in the executives´ compensation packages. The Stock Options have many different characteristics from those options (calls) quoted in the financial markets. Some of these differences are the following: The Stock Option cannot be sold in the secondary markets, which means that you can exercise your option (if it’s convenient) or let them expire, but not sell them. To be able to exercise the Stock Options, usually it is necessary to hold the options for a period of time and following that fixed period the option can be exercised at...