This invention relates to systems and methods for protecting the value of employee stock options from stock price fluctuations. More particularly, this invention relates to systems and methods for creating and processing hedging transactions (i.e., transactions that limit risk) associated with company stock options held by executive employees.
Stock price fluctuations may be attributed to several factors. Stock price fluctuations may be due to general economic conditions such as the business cycle. Other factors may be more specific to the stock issuing corporation's performance and market conditions. Changes in investment liquidity needs, combined with trading frictions and the arrival of new information, may create temporary buying or selling pressures that cause stock prices to change. Typically, changes in stock prices are unexpected.
Some stocks may be more prone to price fluctuations (i.e., more volatile) than others, thereby making them riskier on a relative basis for investors holding the stock and options on the stock. There have been many approaches to hedging against or managing such risk.
For example, it is possible to hedge against the risk associated with a certain stock, by buying or selling options on the stock. For instance, an individual who owns a particular stock may be unwilling to bear potential losses beyond a certain level. Because the price of the stock could drop at any time below this level, owning such stock on an unhedged basis is inherently risky. To hedge against such risk, the individual may purchase a put option giving him the right to sell the stock at a fixed strike price on or before a given date. In such a situation, the investor's position with respect to the stock is hedged against a decrease in the stock price below the strike price of the option. Thus, even if the stock price drops below the strike price of the option, which will result in a loss in the value of the stock, the investor will be entitled to a payment under the option equal to the difference between the put option's strike price and the stock's actual price at the time of exercise. The payment under the put option will offset the investor's loss on the stock.
It is also possible to purchase call options on stocks enabling holders of the call options to buy shares of stock at a predetermined price. Often times, companies provide certain of their employees, typically executives, with incentive or compensatory options pursuant to option plans. Such executives may be awarded stock options as part of the company's strategy to retain and provide incentives for these executives. The executives may exercise their call options and purchase company stock at a predetermined strike price under certain conditions.
Some executives may prefer not to exercise their options for any number of reasons, including expectations regarding the company's future stock performance. They may wish to delay exercising their call options in anticipation of a future increase in the stock price, or in order to delay the taxable event of realizing gain relating to such an increase. Moreover, a substantial portion of an executive's net worth may include the value of his unexercised options. A significant decrease in the company's stock price may result in a substantial impairment of the executive's net worth.
Hedging company stock options by acquiring put options as described above is typically not an alternative for executives. Federal securities laws typically require executives to own actual shares—rather than just the options to acquire shares—that are being hedged by the options. This restriction is designed to prevent these executives from benefiting from a decline in the market price of the company's stock. Moreover, federal tax rules could limit deductions for loss with respect to the purchase price of the put option if it expired unexercised (e.g., if the stock price does not fall below the put strike price).
In order to overcome these and other disadvantages, it would therefore be desirable to provide executives holding company options with systems and methods for limiting exposure to fluctuations in the market price of the company stock that may be acquired upon exercise of the options.