how to create barcode in vb.net 2010 FIVE Valuing Options in Software

Making ECC200 in Software FIVE Valuing Options

CHAPTER FIVE Valuing Options
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Talking with a highly respected options trader like Jon, who deals with investors and corporate clients, was a valuable exercise. What I clearly saw was that valuing options even those granted to executives is very possible. Yes it does require its own brand of rocket science that must be programmed into valuation models. But what was once rocket science now is used in our everyday lives, from launching satellites to monitoring the weather. Similarly the figurative rocket science of option valuation can be applied to the day-to-day corporate world of executive compensation. Executive options do have different characteristics than their traded counterparts. They have very long terms, usually 10 years; they have vesting requirements, during which time they cannot be exercised; many are exercised early once vesting is completed (often after five to seven years, if not sooner); and, of course, they cannot be bought or sold. In fact it is because executives can t buy or sell their options they tend to exercise them early. Despite all these characteristics, executive options can still be valued, taking all of these unique factors into consideration.
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BLACK-SCHOLES AND BEYOND
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Traders are certainly not the only ones who understand option valuations. Economists not only comprehend how to value options, but they have also developed, fine-tuned, and utilized many of the models in use in the marketplace today. Since I took a class in 1979 at the University of Chicago from Dr. Myron Scholes, I went back to him to ask about the valuation of executive options and the use of the model that bears his name. When I reiterated the refrain of complaint that Black-Scholes valuations are too high, he laughed and said, Absolutely not. I asked him if there should be some kind of discount applied to executive options because they are not tradable. Again his reply was, Absolutely not. Remember, he said, the object is to come up with the value of the option to the company not to the executive. The company can deal in its own stock and the derivatives of its own stock with virtually no restrictions. Therefore the value of the option to the company is not directly diminished simply
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because the person receiving that option cannot sell it. However the value of the option may be indirectly affected by the option s lack of marketability because executives will tend to exercise options early that is, before the end of their 10-year term partly because they cannot sell the option itself. That points to the disparity between the value of the option to the company and the value to the individual receiving it. In general options are worth less to the employee than they are to the company. Just as any stock is worth more as part of a diversified portfolio than by itself, options are also more highly valued as part of a diversified portfolio. Options are highly risky derivative securities that should only account for a very small percentage of most portfolios. But even in the case of very wealthy executives, their option grants are often the single biggest component of their entire portfolio of assets. Their options outweigh everything else they have. Because of this imbalance, executives and employees tend to value the options they receive less than what they could potentially be worth. As a dramatic example of this disparity in value, consider the experience of Centex Corporation. The company offered employees the choice of either receiving options or receiving 50 percent of the Black-Scholes value of the options in cash, which would be roughly 25 percent of the face value of the options. For example, if a $54 option had a Black-Scholes value of $27 a share, the company offered $13.50 a share in cash. The overwhelming response was to take the money. A seven-year option is an enormously valuable thing to me, and yet people were willing to take 50 percent of the Black-Scholes value in cash, any day of the week. We had more demand than we had supply for, explained Centex Chairman and CEO Laurence Hirsch. (See Q&A interview with Hirsch at the end of this chapter.) Centex s experience clearly shows that individuals valued the options significantly less than the Black-Scholes value to the company. The thing that would have been interesting, Hirsch continued, would have been if we said, now we re not giving 50 percent of the Black-Scholes value, we re giving 30 percent or 20 percent, and thus found the point at which the seller was neutral in terms of making a decision to hold or sell. But we never got to that point.
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