The Backdating Fiasco - Part One

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Many people consider the world of options to be extremely arcane. Just thinking about these strange instruments, let alone how they are valued, is enough to make most peopleís heads spin. The seemingly impenetrable nature of the option markets has been a major obstacle to the growth of this industry, particularly in the retail sector.

However, as confusing as exchange traded options may appear to the layman, there is another facet of the options world that is far more inscrutable. Iím talking about the shadowy world of corporate options. 

THE EARLY YEARS
For much of the ë90s, options were seen as a panacea for the ills of the corporate world. They provided companies with an inexpensive means to incentivize CEO and employee performance. For many technology startups, they were the only form of compensation available. The promise of a lucrative options payday was a powerful carrot that many people simply could not resist.

This mentality lasted until the boom suddenly went bust. As the tech bubble imploded, it suddenly occurred to analysts and regulators that options, which were handed out like candy in the tech world, had a tangible cost to the issuing firm. Unfortunately, determining that cost is another matter entirely.


THE RISE OF SOX
Sarbanes-Oxley emerged from the wave of corporate bankruptcies and shareholder lawsuits that followed the bust. This legislation forever reshaped the world of corporate compensation by demanding firms actually account for the cost of the options they issue to their executives. The valuing of options may seem like a straightforward proposition.

However, even under ideal conditions, options can be notoriously difficult to value properly. Two people trading the same option using identical pricing models can still arrive at wildly different values depending on how they value volatility, interest, etc. Throw in other complicating factors like competing pricing models and you begin to understand the dubious nature of options pricing. If this level of confusion can exist in the world of liquid exchange-traded options, then imagine the confusion that exists in the nebulous world of corporate options. Unfortunately, there is an additional complicating factor in the corporate world - greed.

THE NUTS & BOLTS
Call options make up the bulk of many executivesí compensation packages. As a result, these executives have a significant incentive to value them as highly as possible. Calls give the owner the right to purchase the companyís stock at a pre-determined price, known as the strike price. This strike price determines the intrinsic value of the option, which is the main portion of its overall value.

For example, XYZ Corporation issues call options to its employees with a strike price of $60.  The stock then rallies to $100, giving those options an intrinsic value of $40 ($100-$60). This value is derived from the fact that employees can exercise the options, purchase the stock at $60 and then immediately resell it at the current market price of $100, netting a profit of $40 per share.

...to be continued.


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