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Book part
Publication date: 4 December 2012

Stephen L. Liedtka and Nandkumar Nayar

The current and widespread view in option trading is that early exercise of call options is suboptimal unless there are large dividend payments on the underlying stock…

Abstract

The current and widespread view in option trading is that early exercise of call options is suboptimal unless there are large dividend payments on the underlying stock (e.g., Finucane, 1997; Hull, J. C. (2008). Options, futures and other derivatives (7th ed.). Upper Saddle River, NJ: Prentice Hall; Poteshman & Serbin (2003)). Our study substantially refines this view by demonstrating that U.S. tax rules governing capital gain holding periods can create incentives for early exercise under certain conditions. Hence, this study adds to the factors that investors likely consider when making option exercise decisions. We further note that recent research documents early exercises in the absence of large dividends, and refers to these option exercises as “clearly irrational.” Predictions of early exercise from our tax-based model are consistent with the observed patterns of early exercise, suggesting that the criteria for denoting an option exercise as “irrational” should be refined to incorporate capital gain holding periods.

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Advances in Taxation
Type: Book
ISBN: 978-1-78052-593-8

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Article
Publication date: 6 March 2009

Joel S. Sternberg and H. Doug Witte

This paper aims to show that tax‐motivated early exercise of US employee stock options can be, in principle, rationalized for bullish executives. The paper aims to show…

Abstract

Purpose

This paper aims to show that tax‐motivated early exercise of US employee stock options can be, in principle, rationalized for bullish executives. The paper aims to show empirical evidence consistent with private positive information guiding the timing of the exercises.

Design/methodology/approach

The paper uses conventional event study methodology to examine the long‐run relative stock price performance of firms in which executives early exercise and maintain the acquired shares. The long‐run analysis adopts the cumulative abnormal return as well as the buy‐and‐hold methodological approach.

Findings

Tax‐motivated early exercise may be justified on the grounds that future stock appreciation can be converted to long‐term capital gains if the shares are held for over one year while, should the stock decline, shares can be sold within a year to count for short‐term losses. The empirical results reveal that executives who early exercise and continue to hold a majority of the shares acquired do so before performance in their company stock is significantly better than a benchmark.

Practical implications

Information‐based early exercise is not a harbinger of poor firm performance, as prior research has suggested. This paper illustrates that private positive information can motivate tax‐based early exercise of employee stock options. Prior research has mostly suggested it cannot. Stock retention upon early exercise indicates the optimism of the exerciser.

Originality/value

The first modeling of an exploitable tax asymmetry upon exercise of US employee stock options. The explicit separation of exercises likely based on positive inside information from those likely based on negative information or other non‐informative reasons.

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Studies in Economics and Finance, vol. 26 no. 1
Type: Research Article
ISSN: 1086-7376

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Article
Publication date: 1 March 2006

Glenn Boyle, Stefan Clyne and Helen Roberts

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are…

Abstract

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are unconstrained in their portfolio choices and thus are indifferent to the specific risk of any firm. By contrast, ESO holders are frequently required to hold portfolios that are over‐exposed to the firm that employs them and so adopt exercise policies that reflect their individual risk preferences. Applying the model of Ingersoll (2006) to hypothetical ESOs, we show that ESO cost can be extremely sensitive to employee characteristics of risk aversion and under‐diversification. This result casts doubt on the usefulness of any market‐based model for pricing ESOs, since such models, by definition, produce option values that are independent of employee characteristics. By limiting employee discretion over the choice of exercise date, vesting restrictions help reduce the magnitude of this problem.

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Pacific Accounting Review, vol. 18 no. 1
Type: Research Article
ISSN: 0114-0582

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Article
Publication date: 20 February 2009

Yan Wendy Wu

This paper seeks to evaluate the cost of repriceable options, and to investigate whether repriceable employee stock options (ESOs) cost more than standard ESOs in…

Abstract

Purpose

This paper seeks to evaluate the cost of repriceable options, and to investigate whether repriceable employee stock options (ESOs) cost more than standard ESOs in providing incentives to employees.

Design/methodology/approach

This paper develops an intensity‐based model, reflecting the special features of repriceable ESOs. The model is used to assess shareholder cost of repriceable ESOs, to explore their early exercise pattern and to compare their incentive effect with standard ESOs.

Findings

Two main conclusions arise. First, option holders of repriceable ESOs postpone their exercise before repricing. But, once the exercise price has been reset, option holders are more likely to exercise ESOs early. Second, option repricing is less cost‐effective than standard options in providing incentives.

Practical implications

This research finds that issuing new options proves more efficient than option repricing in providing incentives. In turn, this research offers a practical guideline to companies confronted with underwater options.

Originality/value

Constructing and applying a more accurate valuation model than those previously developed, this paper investigates several important questions about ESOs repricing. Chiefly, this research helps academics and practitioners better understand the cost of repriceable options, how repricing influences employees’ early exercise decisions, and whether option repricing is cost‐effective in providing incentives. These are important questions to ask, filling gaps in the existing literature.

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Review of Accounting and Finance, vol. 8 no. 1
Type: Research Article
ISSN: 1475-7702

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Article
Publication date: 7 January 2014

John D. Finnerty

More than 80 percent of S&P 500 firms that issue ESOs use the Black-Scholes-Merton (BSM) model and substitute the estimated average term for the contractual expiration to…

Abstract

Purpose

More than 80 percent of S&P 500 firms that issue ESOs use the Black-Scholes-Merton (BSM) model and substitute the estimated average term for the contractual expiration to calculate ESO expense. This simplification systematically overprices ESOs, which worsens as the stock's volatility increases. The purpose of this paper is to present a modification of the BSM model to explicitly incorporate the rates of forfeiture pre- and post-vesting and the rate of early exercise.

Design/methodology/approach

The paper demonstrates the model's usefulness by employing historical exercise and forfeiture data for 127 separate ESO grants and 1.31 billion ESOs to calculate the exercise and forfeiture parameters and value ESOs for nine firms.

Findings

The modified BSM model is just as accurate but easier to use than the more computationally intensive utility maximization and trinomial lattice models, and it avoids the ASC 718 BSM model's overpricing bias.

Originality/value

If firms prefer the BSM model over more mathematically elegant alternatives, they should at least use a BSM model that is free of overpricing bias.

Details

Managerial Finance, vol. 40 no. 1
Type: Research Article
ISSN: 0307-4358

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Article
Publication date: 22 May 2007

Joe Cheung and Charles Corrado

Purpose – The purpose of this paper is to estimate the cost of granting executive stocks with strike prices adjusted by the cost of capital. Design/methodology/approach

Abstract

Purpose – The purpose of this paper is to estimate the cost of granting executive stocks with strike prices adjusted by the cost of capital. Design/methodology/approach – In the paper a Monte Carlo simulation approach developed in Longstaff and Schwartz is used in conjunction with the subjective valuation model developed in Ingersoll to value these executive stock options that are subject to performance hurdles. Findings – The paper finds that standard European Black‐Scholes‐Merton option values overstate the true cost to the firm of granting these executive stock options. The option values also decrease with a higher dividend yield, a higher performance hurdle, a longer vesting period, and a shorter maturity. Research limitations/implications – While the study in the paper is limited to the valuation of executive options, the methodology can be used to study incentive effects of executive stock options that have a performance hurdle. Practical implications – The approach used in this paper to estimate the cost of granting executive stock options is a clear improvement over standard European option pricing approaches that often result in biased estimates. Originality/value – This paper presents a first attempt to integrate the Ingersoll utility‐theoretic model and the Longstaff and Schwartz least squares Monte Carlo algorithm to estimate the subjective value and the objective cost of executive stock options with a performance hurdle. This valuation approach will be useful in the study of other types of executive compensation.

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Pacific Accounting Review, vol. 19 no. 2
Type: Research Article
ISSN: 0114-0582

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Article
Publication date: 2 August 2013

Jianfu Shen and Frederik Pretorius

The purpose of this paper is to construct option pricing models for real estate development by considering and incorporating institutional arrangements, direct…

Abstract

Purpose

The purpose of this paper is to construct option pricing models for real estate development by considering and incorporating institutional arrangements, direct interactions and financial constraints in the model. It extends the application of real option theory from the framework borrowed from financial option pricing, and considers the case where a development company has restrictions from outside environment and financial constraint. It explores the effects of these additional practical factors on real asset project value and development timing. This paper makes contributions to bridge the theoretical models and practical applications.

Design/methodology/approach

Real estate development is modelled in the binomial option pricing framework with the considerations of time‐to‐build, foregone rent if delaying, institutional environment and capital budgeting. The investment timings are derived from the models and sensitivity analysis is conducted to explore the effects of these factors.

Findings

Apart from the factors in traditional option pricing theory, this paper confirms that the contractual covenants, positive synergies between properties and financial status of the firm, which enhance or restrict real flexibility embedded in the development land, influence project value and investment timing. Numerical examples illustrate the effects of these factors. It is argued that the valuation of real options should place emphasis on industry‐specific characteristics and start from the perspective of the firm rather than individual options.

Practical implications

The models constructed in this paper and the results can be directly used in the practical real estate development.

Originality/value

This paper incorporates many practical factors in real estate development which are not investigated in previous studies. It values the option project from the firm perspective rather than project perspective as previous studies. It also shows the effects of institutional arrangement and firm factors on project value and development timing.

Details

Journal of Property Investment & Finance, vol. 31 no. 5
Type: Research Article
ISSN: 1463-578X

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Article
Publication date: 20 April 2010

Peter Klein and Jun Yang

The purpose of this paper is to extend the models of Johnson and Stulz, Klein and Klein and lnglis to analyse the properties of vulnerable American options.

Abstract

Purpose

The purpose of this paper is to extend the models of Johnson and Stulz, Klein and Klein and lnglis to analyse the properties of vulnerable American options.

Design/methodology/approach

The presented model allows default prior to the maturity of the option based on a barrier which is linked to the payoff on the option. Various measures of risk denoted by the standard Greek letters are studied, as well as additional measures that arise because of the vulnerability.

Findings

The paper finds that the delta of a vulnerable American put does not always increase with the price of the underlying asset, and may be significantly smaller than that of a non‐vulnerable put. Because of deadweight costs associated with bankruptcy, delta and gamma are undefined for some values of the underlying asset. Rho may be considerably higher while vega may be smaller than for non‐vulnerable options. Also, the probability of early exercise for vulnerable American options is higher and the price of the underlying asset at which this is optimal depends on the degree of credit risk of the option writer.

Originality/value

This paper makes a contribution to understanding the effect of credit risk on option valuation.

Details

Managerial Finance, vol. 36 no. 5
Type: Research Article
ISSN: 0307-4358

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Book part
Publication date: 15 August 2007

Don M. Chance and Tung-Hsiao Yang

In some contexts, this illiquidity of executive stock options is referred to as non-transferability. In others, the problem is cast in terms of the highly concentrated…

Abstract

In some contexts, this illiquidity of executive stock options is referred to as non-transferability. In others, the problem is cast in terms of the highly concentrated portfolios that managers hold, an implication of which is that managers could not trade the options to diversify. The notion of option liquidity usually conjures up images of trading pits at the Chicago Board Options Exchange or other exchanges. The existence of an active trading pit gives a powerful visual image of liquidity, but, as evidenced by the success of electronic options exchanges such as New York's International Securities Exchange and Frankfurt's EUREX, a trading pit is hardly a requirement for liquidity. The existence of a guaranteed market for standardized options as implied by options exchanges (whether pit-based or electronic) further gives a misleading appearance of high liquidity. There is also a very large market for customized over-the-counter options. It is a misconception to think that these options are not liquid when they are simply not standardized. If an investor can create a highly customized long position in an option, that investor should be able to create a highly customized short position in the same option at a later date before expiration. If both options are created through the same dealer, they will usually be treated as an offset, as they would if they were standardized options clearing through a clearinghouse. If the two transactions are not with the same dealer, they would both remain alive, but the market risks would offset. Only the credit risk, a factor we ignore in this paper, would remain. Hence, these seemingly illiquid options are, for all practical purposes, liquid.2

Details

Issues in Corporate Governance and Finance
Type: Book
ISBN: 978-1-84950-461-4

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Article
Publication date: 20 May 2020

Kiara Lewis, Leanne Livsey, Robert J. Naughton and Kim Burton

Exercise has the potential to provide benefits for people living with dementia, yet the balance of evidence is uncertain. This paper aims to provide an evidence synthesis…

Abstract

Purpose

Exercise has the potential to provide benefits for people living with dementia, yet the balance of evidence is uncertain. This paper aims to provide an evidence synthesis to determine whether exercise improves their health and well-being and what exercise should be recommended.

Design/methodology/approach

Structured search for existing literature reviews on exercise for dementia. Relevant articles were selected and critically appraised against systematic criteria. The findings from 15 high quality reviews were collated by using a best evidence synthesis approach.

Findings

The evidence is convincing for improving physical health, promising for cognitive benefits, mixed for psychological benefits and limited for behavioural outcomes. No evidence of harm was found. Overall, exercise can improve physical and mental health for people living with dementia: there is sufficient evidence to recommend multimodal exercise.

Social implications

The potential beneficial outcomes are of significant importance both for people with dementia and their caregivers. In the absence of more specific findings, the current recommendation for older adults in general is pragmatically justified – some activity is better than none, more activity provides greater benefits. Adding social interaction may be important for psychological and behavioural outcomes.

Originality/value

To the best of the authors’ knowledge, this paper is the first to encapsulate the literature to date on exercise for dementia. Combining the findings from previous reviews enabled a novel synthesis across the range of relevant interventions and outcomes.

Details

Quality in Ageing and Older Adults, vol. 21 no. 2
Type: Research Article
ISSN: 1471-7794

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