c


   


  
 

An option¶s price is affected by a variety of factors in the financial markets. The Black-Scholes
Option Pricing Model is an approach for calculating the value of a stock option. The Black-
Scholes option pricing model is used to determine the equilibrium value of an option. It provides
insight into the valuation of debt relative to equity. (Siegel et al, 1998). In the Black-Scholes
model, the call option is determined by the prevailing share price, the strike price of the option,
the time to expiration of the option, the risk-free interest rate corresponding to the time
remaining on the option, the volatility in share price. The changes of these variables will have an
impact on the prices of the option pricing model.

Firstly, stock price changes have immediate and significant effects on the prices of the call
options. As a stock price increases, the call option will increase because the option is
approaching the adjusted intrinsic value. As the stock price decreases, the price of the call option
will decrease because the immediate exercise of the stock would not be profitable. The option
price changes less than the stock price, but the percentage change in the option price is greater
than the percentage change in the stock price. (Daigler, 1993 ).

Secondly, the exercise price has also effect on the value of the call option. An decrese in the
strike option will increase the value of the call option. For call option, the lower the strike price,
the more beneficial it is for the buyer. As options are struck at lower exercise prices, they will
become more useful for the buyer to profit from the call option. For instance, cosider two call
options, X and Y assumin g X with a strike price of $25 while Y with a strike price of $30. If
these two options are available, any buyer would like to pay the minimum possible amount and
consequently they will choose option X over option Y. Therefore, the price of the call with a
lower exercise price will be more than the call with a higher exercise price.

Thirdly, time to expiration is an important factor affecting the price of the option. The shorter the
time to expiration, the smaller the option price and the smaller the time value. According to
Daigler (1993 ), the relationship between time and option price is related to the probability of the
option buyer obtaining profits (or increasing profits) from a change in the stock price. The
longer the time available, it is more likely that the stock price will increase which will lead to an
increase in the call option price. As time to expiration is shorter, the call option price will
decrease because it is more likely that the stock prices will not change (increase) making the
option more valuable.

Fourthly, risk-free interest rate is another factor affecting the call option price. The relative
importance of this factor is determined by the alternative investment opportunities available and
th costs for investors who trade options. (Daigler,1993 ). Thus, call option is an alternative to
buying the stock. When the interest rate decreases, the cost of financing a stock purchase will not
be high. It will be at a reasonable price. In this case, the stock will become a more favorable
purchase than the option. Thus, the call option price will decrease with a decrease in the interest
rate.

Finally, the stock return variance will also have an impact on the value of the call option. As the
variance of the rate of return on the stock decreases, th value of the option will go down. A call
option on a lower-variance stock would have a lower probability that the stock will go up. In ths
case, profit will not be made. Thus, call option value decreases when the stock return variance is
smaller.
± 

  ±  


ßWA Plc is considering the introduction of an executive share option scheme. It would replace
the existing bonus scheme which is a cash payment to employees and equals to the growth in the
value of holding shares. ßWA is still evaluating whether it should replace its existing bonus
scheme with executive share option scheme. There are several advantages and disadvantages in
both schemes to weigh.

Existing bonus scheme based on performance provides an improved mechanism for aligning
managers¶ interests with those of the company¶s shareholdersi This scheme allows employees to
receive a cash payment that reflects in some way the value created and delivered to shareholders.
There are several advantages fo rthis scheme.

2 

  
 ± 



Since ßWA Plc deliver a cash bonus, managers are motivated to contribute to the goal of ßWA
Plc because cash is the king. From the perceptives of shareholders, there will be no filution of
voting power and their interests since there is no involvement in share issues. Moreover, the
existing bonus scheme is flexible because it can be designed to fit ßWA Plc¶s needs without the
constraints imposed by the use of shares.

However, one of the disadvantage of this existing bonus scheme is management might
manipulate earnings to maximize the compensation of its executives through salary and bonuses.
According to Weil and Maher (2005), one might expect management to try to manipulate
earnings upward if the company is close to reaching target earnings levels that will result in a
bonus to executives. Conversely, when ßWA Plc will clearly miss its arget, management might
have incentive to take a big bath during this period if ßWA Plc will miss the target anyway.
Taking a big bath in one period makes it easier to reach earnings target in the future.

Moreover, the existing bonus scheme might have problems of all accounting measures. Healy
(1985) argues that paying executives on the basis of accounting variables provides an incentive
for management to directly manipulate the accounting system, and favour projects with short-
term accounting returns at the expense of long-term positive NPV investment. The existing
bonus scheme encourages earnings retention and firm size growth, which doesn¶t always equate
with payment of dividends hence shareholder wealth growth.

Finally, the current bonus scheme of ßWA has been linked to earnings per share of the company.
The likely rate of earnings per share (EPS in short) depends upon the assessment as to how
profitably a company is going to operate in the future or what it is likely to earn against each of
its ordinary shares. Since the bonus scheme has been based on EPS, the management will work
hard to maximize EPS. However, maximization of earnings per share (EPS) does not mean
maximization of shareholders¶ wealth because it does not specify the timing of expected returns
and it does not consider the risk or uncertainty of the prospective earnings stream.

Moreover, EPS is based on past data and it is easily manipulated by changes in accounting
policies and by mergers or acquisitions. The use of the measure in calculating management
bonuss makes it particularly liable to maipulation. Investors should be more concerned with
future earnings which are more difficult to reach than the readily available past data. These are
several merits and shortcomings of the existing bonus scheme. When ßWA Plc considers
introducing share option scheme, relative merits for this proposed executive share option scheme
should be taken into account.

2 

  
 ±  


Executive share option scheme allows managers to buy up to a certain number of shares in the
company during a specified period in the future but at a price fixed now. (Bender and Ward,
2009). The reason why ßWA Plc and most companies want to have this bonus scheme is that
they want to achieve goal congruence between shareholders and management.

This scheme works in the same manner as any call option. If the management can achieve
growth in the price of the shares during the option period, they can make a capital gain by
exercising their share options. If the share price falls, there is no value created for management
by having this option scheme. Thus, management will motivate to grow the value of the share
and maximize wealth which is along with the interests of shareholders. This is the primary logic
behind the use of executive share options scheme in that it is supposed to create goal congruence
between the objectives of the shareholders and the managers. Both parties will be rewarded if
the share price increases.

Agrawal and Mandelker (1987) reported that executive share options scheme encourages
management to make investment and financing decisions which increase the variance of the
firm¶s assets. As ownership of the company by inside managers increases, their incentive to
invest in positive NPV projects and reduce private perquisite consumption also increases. The
higher the value of the firm, the higher the value of the options and the profit managers can make
upon exercising them. Additionally, Denis et al. (1997) found that executive ownership is
associated with greater corporate focus, indicating that the severity of the managerial risk-
aversion problem may be reduced through higher equity stakes. Therefore, the best thing of using
executive share options scheme is to increase the motivation of managers of ßWA Plc achieving
goal congruence with its shareholders.

The proposed bonus scheme also offer tax advantage. Since share options are not transferable,
their fair market value cannot be readily determined. Therefore, when an executive share option
is introduced, it is not taxable. This will deliver greater rewards for executives at lower cost to
shareholders. However share options scheme has also several limitations in their ability to
incentivize management to create shareholder value.

An executive share option scheme might brng dilution problem to the company. For example, if
many managers try to exercise their options in order to take advantage of gains in the market
price, it can collapse ßWA Plc's whole equity structure. The company is required to issue new
shares of stock when management exercise their options. This increases the number of shares
outstanding and dilutes the value of stock held by shareholders. Therefore, the implementation of
an executive share option scheme rreholders to sanction a significant dilution in their own
investment in the comapny.

Moreover, according to Armstrong and Murlis (2004), executive share option scheme is often
unsuitable for established companies because of share price volatility. This typically means
meaningful option profits will only be delivered by inappropriately large option awards.
Another weakness of executive option scheme is a disproportionate incentive problem. A
disproportionate incentive problem encourages executives to manipulate outcomes and
frequently leads to disputes. (Gerard, 2006). It can also cause serious problems of demotivation
if critical reward thresholds are narrowly missed. When EPS growth is the performance measure
then manipulation of outcomes becomes an issue of particular concern. Gerard (2006) argued
that accounting rules give the directors some discretion on how provisions, accurals and
exceptional items are shown in the accounts. This discretion should be used to ensure that the
accounts true and fair as possible. It should not be used to maximize the records paid under the
executive share option scheme.

These are the relative merits for ßWA Plc of the existing bonus scheme and the proposed share
option scheme. Moreover, Black-Scholes option pricing model is applied to evaluate whether or
not the proposed share option scheme is likely to be attractive to middle managers of ßWA Plc.

2 
 


The Value Of The Call Option ßsing Black-Scholes Option Pricing Model

The value of the call option is calculated by using Black-Scholes option pricing model. It can be
seen as follow.
ln(S0/K) + (r + ı2/2)T
d1 =
ı¥T

ln(586.41/500) + (6% + 0.382/2)

d1 =
0.38¥1

d1 = 0.7674

d2 = d1 ± ı T = 0.7674 ± 0.38 1 = 0.3874

N(d1) = 0.5 + 0.2794 = 0.7794

N(d2) = 0.5 + 0.1480 = 0.6480

C = 586.41*0.7794 ± 500*e-0.06*10.6480 = 150.2

As a result from call option, the price of the call option is 150.2 pence. The executive share
option scheme bonus is at £7506.89 whereas the existing bonus ranges between £5,000 and
£7,000. According to this result, a proposed executive share option is more attractive to senior
mangers of ßWA Plc comparing to the existing cash bonus.

However, there are other factors to be considered for senior managers. This relates to dividend
policy. Shareholders receive return from the investment either through capital growth or by the
payment of dividends. If ßWA Plc does not have available potential reinvestment projects that
generate its shareholders¶ expected return, paying dividends is preferred to retaining profits for
growth. In such case, shareholder value is created by increasing dividends.

In this case, from the perspective of mangement, there will be no incentive for them to pay
increased dividends during the life of any significant share option scheme. Bender and Ward
(2009) explained that if the excess funds are retained within the company, rather than being paid
out, the price of the shares should increase to reflect the cash held by the company, even though
shareholder value may be being destroyed by such a dividend policy. Thus, senior manager of
ßWA Plc might not pay dividends to shareholders during the life of executive share option
scheme. In this case, management will not act in shareholders; interests. If dividen paid, forgoing
cash for shares is not worth for managers.

Another is stock fluctuation relative to the life of the bonus scheme. Share movements may take
some time to reflect the effort ßWA Plc has made. This with the general vagaries of equity
investment can mean that the time it takes for shares to provide a good return may well be longer
than the timescale available to the senior management under the share option scheme. If senior
manager resign prematurely, the options will lapse and he/she will not get any bonuses.

Finally, senior managers should consider if share price keeps falling. According to Garrett
(2008), the value of options will move in tandem with the underlying asset. When the share price
keep falling, the option has no economic value at all because managers will not exercise options.
In this event, forgong cash is not worth to managers. Overall, these factors should be considered
to management although the proposed share option scheme is more attractive to management
than the exisiting cash bonus scheme.

 


When told of the scheme, one manager stated that he would rather receive put options than call
options. Put options allow their holders to profit from declines in stock values because they allow
stocks to be bought at market price and sold for the higher option price. If ßWA Plc offers put
options scheme, management will not motivate to do share price goes up. Instead, they will want
share price to go down because of their put option scheme. Therefore, there will be conflict of
interest between shareholdes and management and thus share price will not go up and
shareholders¶ wealth will not be maximized. Logically ßWA Plc should not agree to offer put
options scheme to its senior management.

One more thing to be taken note of in this case is that why this manager wanted to have put
options. Since he wanted to get put options, he was betting the share price of ßWA Plc will go
down. According to agency theory, managers (agents) are acting behalf of shareholders
(principal) for the company. Regarding information and operations of ßWA Plc, management
knows better how the company is going than shareholders. Since this manager was betting share
price will drop, it is questionable for the operation of ßWA Plc. This is a negative sign for ßWA
Plc¶s shareholders.

  

According to (Megginson and Smart, 2008), put-call parity is a relationship that links the market
prices of stock, risk-free bonds, call options and put options. This means that the prices of put
and call options on the same underlying stock, with the same strike price and the same expiration
date, must be related to each other.

Pp = Pc ± Ps + Ke-rT

= 150.2 ± 586.41 + 500*e-0.06*1 = 34.67

Put-call parity also prove that put options would not be more valuable to managers since its value
is lesser than the value of the call option.
Overall, using the Black Scholes model to calculate the call option price for ßWA Plc is to
compare the value of the current bonus. However, the Black Scholes model is not a perfect
estimator of option prices because it relies upon the assumption that the price volatility will
continue for the relevant future period. In reality, price volatility might be quite different.

To conclude, the performance-related elements of remuneration should be designed to align the

interests of directors and shareholders and to give directors keen incentives to perform at the
highst levels. (Hopt and Wymeersch, 1997). An executive share option motivates senior
management by giving them to buy shares at a future date for their market price at the time th
eoption was granted. However, ßWA Plc should consider whether all employees should be
eligible for benefits under an executive share option scheme.

In fact, the executive share option scheme is preferred by employees at upper ranking such as
directors and senior managers. Employees at lower-level will not be interested and motivated by
the exisitng cash bonus sceheme because they assume cash is king. Therefore, ßWA Plc should
not introduce an executive share option scheme to all employees. Moreover, the proposed
executive share option scheme should be preferably replaced over the exisiting cash bonus
scheme and must be approved as a whole by all shareholders.

Ê



1.Ê AGRAWAL, A. AND MANDELKER, G. 1987. Managerial Incentives and Corporate

Investment and Financing Decisions, l
  
, 42 (4), 823-837.
2.Ê ARMSTRONG, M., AND MßRLIS, H., 2004.        

  

 5th ed. ßK: Kogan Page Limited.
3.Ê BENDER, R. AND WARD, K., 2009. [    
 . ßK: Elsevier
Butterworth-Heinemann.
4.Ê DAIGLER, R.T., 1993.  
              
 

 
! . ßSA: McGraw-Hill Companies,Inc.
5.Ê DENIS, D.J., D.K. DENIS, AND A. SARIN. 1997. Agency Problems, Equity
Ownership, and Corporate Diversification, l
  
 Vol. 52, pp. 135-160.
6.Ê GARRETT, S., 2008.     "
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 . ßSA: Wiley
Publishing, Inc.
7.Ê GERARD, P., 2006.  
   !  #%

     $ 
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ßK: Matador.
8.Ê HEALY, P. 1985, The Effect of Bonus Schemes on Accounting Decisions, l
 


  #
 
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9.Ê HOPT, K.J., AND WYMEERSCH, E., 1997. [   [   ' 
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Berling: Walter de Gruyter & Co.
10.ÊMEGGINSON, W. L., AND SMART, S. B., 2008. 

  [   
.
ßSA: South-Western Cengage Learning.
11.ÊSIEGEL, J. G., SHIM, J. K., AND HARTMAN, S. W., 1998. 

()

'
 
*
  
+,-$
 .!   *
   
  

 

. ßSA: McGraw-Hill Companies,Inc.
12.ÊWEIL, R. L. AND MAHER, M.W., 2005.   [ !. 2nd ed. New
Jersey: John Wiley & Sons, Inc.

  
   
±  

McDonald¶s Corporation has investments in over 100 countires. It considers its equity
investment in foreign subsidiaries to be at risk, subject to hedging depending on the individual
country, currency and market. The ß.S. parent company possesses three pound-denominated
exposures arising from the British subsidiary:
(a)Ê The equity capital the parent company has in the subsidiary (originally ßS$ but now
poud-denominated)
(b)ÊIntra-company debt in the form of a 4-year fixed rate (5.30%) £125 million loan
(c)Ê An inflow stream of royalities arising from payment by the British subsidiary of a
percentage of sales (£) to the parent company in the ß.S.

In addition to these exposures, a detail of ß.S. accounting practices is noted about the
³permanence´ of the intra-company loan.
áÊ If the loan is designated by McDonald¶s as permanently invested in the British
subsidiary, it is in essence equity capital in character and any foreign exchange gains and
losses arising from debt service flow only to the CTA account on the consolidated books.

áÊ If the loan is designated by McDonald¶s as not permanently invested in the British

subsidiary, the foreign exchange gains and losses arising from debt service will flow to
the profit and loss statement of the parent company itself, possibly altering consolidated
earnings (and EPS) of the company.


 



  

In this case, the three primary exposures McDonald¶s has relative to its British subsidiary can be
hedged by using cross-currency swap. Cross-currency swaps are financial instruments that allow
financial managers to capture existing and expected floating or money market rate spreads
between alternative currencies without incurring foreign exposure. (Musiela and Rutkowski,
2005).
Currently, the British subsidiary of McDonald's is borring at a fixed interest rate. With cross-
currency swapping, McDonald's is able to break down its fixed interest rate and can adopt the
floating interest rate from its ßS parent company. This is participating in the swap of floating for
fixed. Because of the cross-currency swap, there will be a drop in the floating interest rate and
thus reducing fluctuating payments of McDonald¶s.

McDonald's swap hedging model is seven years in length and allows it to receive dollars for
payment of pounds. ßsing this swap McDonald's will be paying out pounds and thus slowly
reducing their holdings of the foreign currency. With each payment, they are reducing the risk
associated with the pound and their investment in a foreign country. The repatriation of royalties
are being hedged to avoid future, more expensive payments too. Swap hedging occurs as
McDonald's is trying to lock-in the cost of payment over a seven-year agreement and hedge
against rising costs of paying for the pound and locking in the dollar so that the cross-currency
swap is more effective.

In the end, the large ending payment on the principal involved in the swap effectively hedges
against changes in currency values and protects McDonald's against the possibility of rising costs
of the pound over time, and hedges against losses in the value of the dollar. However,
McDonald¶s should also be aware of its risk. The British subsidiary might face the added risk of
increasing the interest rate with the float.

According to Eiteman  (2010), whether a particular company will find this attractive or not
depends on at least three factors:
(1)ÊCorporate philosophy towardsforeign exchange gains/losses in general,
(2)ÊWhether the investment in the foreign subsidiary is for the very long-run, and
(3)ÊWhether the currency (in this case the British pound) will trend up or down versus the
dollar over an extended period.

Overall, McDonald¶s corporation¶s British pound exposure can be effectively hedged by using
cross-currency swap. The British subsidiary also takes on the added risk that the interest rate may
increase with the float. Thus, the financing and hedging decisions by McDonald¶s should not
only reflect economic and financial criteria but also should consider the result of constraints
imposed byshallow domestic capital markets and bureaucratic controls.
Cross-currency Swap and The Long-term Equity Exposure

Exchange rate exposure is the degree to which a company may be affected by exchange rate
changes. A company with cash inflows and outflows over time in more than one currency faces
currency exposure. If the overall cash inflows, in terms of a given currency, cannot be matched
exactly in time and amount to the cash outflow in the same currency, the firm faces currency
exposure and possible losses because of fluctuating exchange rates. (Malhotra and Evans, 1995).
Consequently, various hedging instruments, such as forwards, futures, options, and swaps, must
be used to manage exchange rate exposure.

A key characteristic of the exposure arising from the existence of foreign subsidiaries, such as
net worth exposure, is its long-term duration. According to Clark and Judge (2009), besides the
cost and complexity of monitoring and managing the currency risk from foreign subsidiaries
with short-term derivatives, the mismatch in the durations of the hedge and the exposure would
result in a higher level of basis risk relative to a hedge whose maturity more closely matched that
of the exposure. They further explained that long-term foreign currency debt or a long-term
currency swap would simplify the risk management and reduce basis risk through a reduction in
the duration differential.

Foreign currency exposure arising from the receipt of foreign income from other sources, such as
payment of royalties, dividends, interest on loans and the repatriation of profits by foreign
subsidiaries might be better hedged with a currency swap given its flexible nature than by issuing
foreign debt directly. (Clark and Judge, 2009). The exposures McDonald¶s faces are long-term
exposure and thus using currency swap will be more effective to McDonald¶s than using future
or forward contracts.
The use of the cross-currency swap as hedge to the parent can be explained with a simple
balance sheet of the ß.S. parent company by the nature of the exposures.

Assets of ß.S. Parent Company Liabilities of ß.S. Parent Company

(Swap $ payment for £ payment)
£ inflow over time -----$ A/R of royalties Interest payment on swap ----$ £ outflow
£ inflow over time -----$ Interest on loan Outstanding notional principal on swap -----$ £
£ exposure, long term -$ Equity in subsidiary exposure

As described in the table, dividend distribution and royalities from the British subsidiary and
principal and interest payment on intra-company debt are cash inflows denominated in pound to
ß.S. based McDonald¶s Corporation. These asset-based pound inflows could then be off-set by
creating pound-denominated cash outflows from a cross-currency swap to pay pounds and
receive dollars. Interest payment would now be in British pounds. The principal payment on the
cross-currency swap at the end of the agreement effectively replicated a long-term exposure
investment in its British subsidiary.

This is a cross-currency swap and requires McDonald's to make regular payments in pounds and
a final principal repayment when the swap agreement has ended. All in all, this is by most
measures a very effective use of cross-currency swaps for hedging currency exposures on an on-
going or operating basis.



 
 
  !

The newly proposed accounting standard at the time, FAS 133, would require that McDonald¶s
mark-to-market the value of the outstanding swap on a regular (quarterly) basis, and include the
resulting gains/losses on the swap in Other Comprehensive Income (OCI). The potential impact
of FAS 133 on the hedgind strategy of McDonald¶s should be considered. ßnder FAS 133, the
firm will have to mark-to-market the entire cross-currency swap position, included principal, and
carry this to other comprehensive income (OCI).
Marking-to-market involves settling the variation in the contract value on a regular daily basis.
(Jorion, 2009). McDonald¶s has cross currency swaps, with the purpose of managing the
exchange rate fluctuation related risk, through which it swaps pound denominated debt into
dollar denominated debt. The mark to market of these instruments is calculated with the
exchange rate and interest rate market prices that would apply to terminate the above-mentioned
contracts at the end of the period. ). Thus, the value of a swap hedge changes by its marking-to-
market value depending on changes both in interest rates and foreign exchange rates. The
contracts are designated as cash flow hedges; the changes in the mark to market are recorded as
other comprehensive income (OCI).

Marking-to-market a cross currency swap will likely result in very large swings in the value of
the position from period to period. This is a result of changes both in interest rates and foreign
exchange rates. As both interest rates and exchange rates change, long term swaps with large
notional principals outstanding in the distant future will change significantly in value.

Other Comprehensive Income (OCI) is another measure of consolidated income which firms
conforming to ß.S. accounting practices (ßS-GAAP) must report. Other Comprehensive Income
(OCI) refers to changes in net assets that are not transactions with owners and that do not appear
on the income statement. (Stickney   2010). Since it includes all adjustments that are
normally only reported through the balance sheet, so that the reader of the income statement wil
have a clearer idea of not only the results of company, operations, but also of valuation issues
that are caused by forces outside of the reporting entity.

It is in essence the normal consolidated profits of the firm plus change in the retained earnings
account of the firm ± which is often largely the value of the CTA account for a MNE. Obviously,
combining the CTA account change in value with current consolidated income could potentially
result in volatile movements in the combined OCI measure.
The cross-currency swap is hedging actual cash flows which are moving between the subsidiary
and the parent, whereas the concern over FAS #133 is primarily an accounting-based
measurement issue. Therefore, actual cash flow is more important than accounting-based
measurements.

OCI is not the measure of earnings which is popularly reported and focused on by Wall Street,
and most of the true analysts who follow firms will understand the distinctions. OCI may
increase substantially earnings volatility and or show losses that could substantially reduce the
reported earnings. Over these seven years of swap,OCI of McDonald¶s might move its Total
Comprehensive Income lower or higher. If OCI were directly in the earnings statement, it would
have decreased earnings by movement for those years. With the equity markets up or down, OCI
is likely to add or reduce substantially to Total Comprehensive Income. Thus, McDonald¶s
should analyze the effects that OCI has on total comprehensive income. Most importantly, they
should then consider whether OCI if substantial, will affect Total Coprehensive income in the
same way in the future.

All things considered, if two different firms had the same basic performance on an EPS basis, but
one firm had a significant deterioration in its reported OCI as a result of marking-to-market its
cross-currency swap (hedge) position as in the case of McDonald¶s, would the firm be punished
by the market? To date, McDonald¶s has continued to follow the FAS #133 debate closely and
continually reviews its currency hedging strategies and accounting policies and practices.



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