Finance Project - Essay Example

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Stock options are a form of compensation granted to an employee, by an employer, in lieu of salary and wages. Stock options grant employees the right to purchase a certain number of shares at a given price. Traditionally, firms have compensated their employees through some combination of salaries, commissions, or bonuses…
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Finance Project
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Download file to see previous pages Stock options encourage managers to maximize shareholder value. Although stock options were once reserved for upper management, there has been a trend to include more employees.
Generally, the future purchase price, or strike price, is equal to the market price of the stock at the time of grant. When an employee exercises options, he or she pays the firm the strike price for the shares, regardless of the then- current market price. Employees usually remain with the firm for a specified period before options vest. Upon vesting, the employees may exercise their options. If an employee leaves the firm, outstanding vested and unvested options are forfeited or cancelled. Options not exercised by a date specified in the option contract will expire. When an employee decides to exercise their stock options, they may either purchase the underlying stock at a discounted price or receive an equivalent cash premium. This transfer from the firm to the employee becomes part of the employee's taxable income for the year.
Firms now grant stock options to a much broader range of employees for many reasons. A firm's motivation in implementing a stock option plan includes increased employee productivity, the attraction and retention of valuable human capital, reduction of short-run compensation costs, increased cash flows, and higher levels of book income.
Individuals, employers,...
Stock options' ultimate value to the employee depends on the future stock performance. Consequently, the stock option value is uncertain at the time of grant.
Literature Review
Arbitrage pricing arguments can be extended to allow for diversifiable risks. In equilibrium, these risks will be fully diversifiable and have zero prices. Thus every asset can be priced exactly (or approximately) as a linear combination of a relatively small number of common factors. Although this is instructive for introducing basic ideas of arbitrage, aggregation, and diversification, we require a multiperiod framework to capture a range of intertemporal problems. For example, we would like to investigate the term structure of interest rates, complicated multiperiod derivative securities, the dynamics of stock prices, and dynamic hedging strategies. It will turn out that our two-period analysis has laid an important foundation for this analysis. By choosing an appropriate dynamic framework, we can generalize our two-date results, and obtain obvious sophisticated reinterpretations of familiar results.
Pastor and Stambaugh (2000) provide further details through an investigation of the portfolio choices of an investor seeking a mean-variance efficient portfolio by comparing the risk based model of Fama, and French (1993) and the characteristic based model of Daniel, K. & Titman, (1-33). They report that there is virtually no difference between the risk- and characteristic-based models, as both lead to similar portfolio choices within the investment universe. (Michael, 119)
While debate continues over explanatory basis of the various multifactor models, the essence of the argument remains the ...Download file to see next pagesRead More
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