Stock Options and Permanent versus Transitory Income - Essay Example

Stock options do provide an opportunity to all sophisticated investors. This is because the power of choices is in their versatility, and it enables the investor to adjust their position as per the prevailing situation or circumstances. However, this versatility has its cost and, therefore, the investors should assess this extra cost based on their knowledge and skills. Options also involve a risk that is not suitable for all investors. One should, therefore, be in a position to evaluate the risk associated and develop measures for managing such risks.

Being ignorant of such risks will place the investor in a weak position. Stock options are the agreement between two parties to sell or buy an asset. It is the contract that gives one party the right. It does not give the responsibility to buy or sell an asset in the future at a pre-set price known as the strike price or exercise price (Fabozzi, 2008). There are two types of options; call option and put option. A call option is a financial contract that gives the buyer the right but, not the obligation to acquire a given number of assets in the future at a predetermined price.

On the other hand, the put option gives the right but not the obligation to sell a specific number of underlying securities at some future date (Fabozzi, 2008). It is essential to review the proforma quantification in the footnotes periodically to access more information concerning the options. Even though the expense is expected not to persist, it changes as the situation changes, and as investors, one should continually assess the information to be able to adjust the value or the cost of the option.

Question 2Permanent vs. Transitory income consumer spending theory states that people spend their money at a level that is consistent with their expected average income. The steady average income which is long term is referred to as permanent income. Any individual will only save if his or her current income is higher than the expected permanent income (Thaller, 1981). This implies that people will only keep the excess income. This hypothesis of permanent income was developed by an economist known as Milton Friedman.

Transitory income refers to this excess money that is available for saving. Another traditional economist by the name of Keynesian argued that the consumption pattern of the people will depend on their after-tax income. The government does regulate transitory income through a concept known as fiscal policy (Thaller, 1981). In summary, transitory income is the difference between the current revenue and the permanent or expected income. For corporations, the difference between the book income and the taxable income is a result of items of expenses and revenue recognized for tax in one period but different from the books.

This means that the income recorded in the books in the proforma financial statements may vary from taxable income. This difference is brought up by some features such as depreciation which is not an allowable expense for taxation (Klemm, 2007). The variation can also be caused by changes taking place in the preparation of the proforma financial statements and the final statements. It is vital to conduct the right forecast of future activities that could affect the financial statements. However, in the long run, these items cause no difference in the two types of income.