May 08, 2003

Last (Formal) Office Hours of the Semester

As the spring semester spins to a close, I had my last (formal) Wednesday afternoon office hours yesterday. Office hours have been a lot of fun this semester, and yesterday was no exception: an undergraduate thesis that has leapt back onto track (yay!), a student signing up for a reading course in Austrian political economy over the summer (which will be interesting), graduate student papers inching toward completion, scheduling lunch with the delightful Trevon Logan, a very interesting conversation about Eichengreen and Flandreau, eds., The Gold Standard in Theory and History, and two pleasant surprises:

The first pleasant surprise was Hal Varian, who last week I said was one of those whom-I-never-see-on-the-Berkeley-campus. He came wandering over from his haunts among the SIMians to the Economics Department's Wednesday afternoon coffee, and said many interesting things. Among the most interesting things was how Coca Cola values the options it grants to its executives: it issues a few more, auctions them off, and sees how much money they bring in.

The second pleasant surprise was Sumana Harihareswara (Berkeley Political Science '02), who has smart views on why comments sections of weblogs (and everything else collective on the internet) tend to degenerate rapidly to USENET levels of chaos and unpleasantness without constant very heavy lifting by formal or informal moderators. It makes me feel grateful (most of the time) toward my own comments section, where people are (somewhat) more likely to speculate on whether they would rather be a twelfth-century crusader warlord or a twenty-first century dock worker at target than to call each other Nazis...

Posted by DeLong at May 8, 2003 10:14 AM | TrackBack

Comments

Regarding Coke's options accounting scheme:

There is much to be said for this method, and it certainly overcomes many of the problems with using Black-Scholes or some other options-pricing formula to calculate a value for stock options that we would presumably run through the income statement as an expense.

But its still no magic bullet. The fact remains that options will still be more valuable to corporate employees who have some control over the company's prospects than they will to arm's-length investors, all things being equal (if the underlying stock starts to tank, executives can work long hours to try to right the ship; investors cannot). Thus Coke's method understates the value. But also, employee stock option grants typically vest over a period of time tied to the employee's continuing employment (if you quit you lose your options), and since this reduces the employee's marketability during the vesting period, the options are less valuable to the employee than they would be to an over-the-counter investor. Thus Coke's method overstates the value. Between these two competing forces, which wins?

Plus its not entirely clear that every public company could replicate Coke's ability to just sell off some spare options. Coke is a houshold name and a blue-chip company. It should have no problem making a relatively liquid market in its own options. But a start-up microcap (in other words, the kind of company that's MOST likely to rely on options as a significant portion of compensation) might find it very difficult (or incredibly costly and time-consuming) to sell off enough of its own options on an open market to get a fix on the arm's length price. I mean, would you buy 5 year calls on some obscure software house or fast food niche player? Wouldn't you require a significant discount to the "true" value of the security to compensate you for the pain-in-the-ass factor of researching and understanding it?

Posted by: sd on May 8, 2003 10:40 AM

re: coke options.

i could be totally wrong about this (not having followed this for a little while), but my understanding was that Coke would ask a couple of investment banks to offer bid/asks for its options. Now Coke would offer the maturity terms (in the FAS parlance, "the expected life"), and then banks would offer a price (so, the only truly market driven input is the volatility). Yet, Coke can quite easily manipulate the value of the option by changing its assumption of the expected life (though the contractual life would be unchanged).

Now, i'm the first to admit that it is incredibly hard to predict how and when employees will exercise their options (in gross violation of typical option pricing models). Yet, i wouldn't be surprised if they are quite aggressive in shortening the expected life of the options they put out to bid.

My view: good PR, but nothing has really changed.

Posted by: Sumit on May 8, 2003 12:49 PM

Coke's idea is a good one. But do they hold enough options back to put some up for auction next year, and the year after that, ...? Because they will change value of course.

Posted by: Andrew Boucher on May 8, 2003 01:16 PM

The funny thing is that the banks turned around and valued the options according to Black-Scholes, even though the whole idea was to avoid that because it underestimated the option value (according to Buffett). This was written up in the WSJ recently.

Posted by: Daoud Nagitar on May 9, 2003 10:50 AM
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