8

Stock Options Plans Hedging

This chapter briefly describes the main stock-based compensation plans. These plans include all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. I will start by describing the main plans. I will continue by reviewing the IFRS accounting for these plans. A good understanding of the accounting for stock-based plans is crucial in order to implement a sound hedging strategy. Next, I will examine the most common hedging strategies for hedging stock options plans, including some innovative strategies to reduce the cost of hedging these plans. Finally, I will discuss HSBC's share performance award, a highly structured share plan.

8.1 MAIN EQUITY-BASED COMPENSATION PLANS

Equity-based compensations plans are a tool to further align employee interests with those of the company's shareholders by enhancing further the link between pay and long-term performance. These compensation plans are typically discretionary, providing flexibility to reward particular achievements or exceptional performance. As a result, most compensation plans are granted to senior key talent who are actively leading the drive to achieve sustained profitability at the company and who are expected to contribute most significantly to its long-term future and economic success.

8.1.1 Main Equity-based Compensation Plans

In this section I will briefly cover the major share-based compensation plans. Continuously, human resources consulting firms are developing new types of plan. Additionally, changes in tax regimes usually bring new types of plan. However, most plans can be classified under one of the following categories.

Stock Options Plans

An employee stock options plan (ESOP) represents the right awarded to certain employees to purchase a number of common shares of the company at a pre-agreed exercise price, commonly subject to certain conditions. The exercise price is usually set at the market price of the underlying shares on the date of grant or an average of the stock price during a period up to the date of grant.

Stock Appreciation Rights

A stock appreciation right (SAR) plan provides eligible employees of the company with the right to receive cash equal to the appreciation of the company's common shares over a pre-established strike price. Therefore, a SAR is a cash-settled ESOP.

Share Plans

There are many variations to share plans. In general, employees of the company either voluntarily buy shares of the company in advantageous terms, or are granted a number of shares for free.

The most common design of a share plan, the so-called “equity plus plan” or “leverage share savings plan”, is a voluntary plan that gives eligible employees the opportunity to purchase shares of the company at the stock price on the purchase date and generally receive at no additional cost a number of shares (e.g., two shares) for each share purchased, up to a maximum annual limit, after a certain vesting period of several years (e.g., three). Commonly, the free shares to be received are forfeitable in certain circumstances.

Another typical design of a share plan is a voluntary plan, the so-called “discounted purchase plan”, that gives eligible employees the opportunity to purchase shares of the company at a discount to the stock price on the purchase date. Shares purchased under the share plan are restricted from sale during a certain period (e.g., three years) from the time of purchase.

As mentioned earlier, there are all sorts of variations to the two previous designs. At the end of this chapter, the share plan awarded by HSBC is covered, which in my view is one of the most complex I have seen.

Employee Stock Ownership Plans

An employee stock ownership plan (trust ESOP) is a retirement plan in which the company contributes its stock to a trust for the benefit of the company's employees. This type of plan should not be confused with employee stock options plans, also called ESOPs, which we saw earlier. The structures of trust ESOPS vary, but typically they are arrangements whereby a trust is set up by the company to acquire shares in the company for the benefit of the employees. Therefore, in a trust ESOP, its beneficiaries do not hold the stock directly (i.e., beneficiaries do not actually buy shares). Instead, the company contributes its own shares to the trust (i.e., the plan), contributes cash to buy its own stock, or, quite commonly, the plan borrows money from the company to buy stock. The structure of the plan is designed to benefit from significant tax advantages for the company, the employees and the sellers. Employees gradually vest in their accounts and receive their benefits when they leave the company (although there may be distributions prior to that). Hereinafter, I will use the term ESOP to refer to stock options plans only.

8.1.2 Terminology of Stock Option Plans and SARs

There are specific terms of stock option plans and SARs. The main terms are the following:

8.2 IFRS ACCOUNTING FOR EQUITY-BASED COMPENSATION PLANS

This section reviews the accounting under IFRS for equity-based plans. The accounting standard that guides the recognition of share-based payments is IFRS 2 “Share-based Payment”. IFRS 2 defines a share-based payment as a transaction in which the entity receives or acquires goods and services either as consideration for its equity instruments or by incurring liabilities for amounts based on the price of the entity's shares or other equity instruments of the entity. The accounting requirements for the share-based payment depend on how the transaction will be settled:

• The issuance/delivery of equity (stock options plans, share purchase plans).
• The delivery of cash (SARs), or the issuance/delivery of equity with a cash alternative.

Frequently, an option right may only be exercised if specific performance targets, called conditions, are met during the vesting period (see Figure 8.2).

IFRS 2 groups all conditions between non-vesting conditions and vesting conditions:

• Non-vesting conditions are conditions that determine whether the company receives the services that entitle the counterparty to the share-based payment. If a non-vesting condition is not met, the company is not receiving the “work” that entitles a beneficiary to the share-based payment. For example, a company may grant stock options to a board member on the condition that the member does not compete with the company during the vesting period. If the board member leaves to work for a competitor during the vesting period, the award is terminated. Another example of a non-vesting condition, for share plans, would be a requirement for the employee to make investments in the company shares.
• Vesting conditions are conditions other than non-vesting conditions.

Under IFRS 2, vesting conditions are divided into service and performance vesting conditions:

• Service vesting conditions are conditions that if not achieved result in forfeiture, such as the beneficiary's employment during the vesting period.
• Performance vesting conditions are vesting conditions other than service conditions.

Under IFRS 2, performance vesting targets are divided into market and non-market vesting conditions:

• A market vesting condition is defined by IFRS 2 as “a condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price of the entity's equity instruments, such as attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving a specified target that is based on the market price of the entity's equity instruments relative to an index of market prices of equity instruments of other entities”. In summary, a market vesting condition is linked to the equity markets.
• A non-market vesting condition is a performance vesting condition other than a market condition. For example, an award may be exercised only if a certain earnings-per-share is met, or a certain EBITDA growth is achieved.

8.2.1 Accounting for Stock Options Plans

As we saw earlier, stock options plans can only be settled by delivering shares to the beneficiary. The settlement exclusively in shares establishes the rules for the plan's recognition, as follows.

Accounting Entries on Grant Date

On grant date, the fair value of the “equity option” is estimated. An important ingredient of this estimate is the fair value of the equity option embedded in the award (see Figure 8.3), which is determined using an option-pricing model, typically the Black–Scholes model. The model takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, the expected dividends on it and the risk-free interest rate over the expected life of the option.

• The expected life of the option is estimated using various behavioral assumptions, for example, exercise patterns of similar plans.
• Market vesting conditions and non-vesting conditions are taken into account when estimating the fair value of the equity instruments granted.
• Non-market vesting conditions and service conditions are not taken into account.

No accounting entries take place on grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award is calculated (see Figure 8.4). The expense is measured by adjusting the fair value of the equity option that was calculated on grant date for the expected likelihood of meeting the non-market vesting and service conditions. For example, if there is an 80% chance of achieving the non-market vesting and service conditions, the number of options is adjusted by multiplying the options’ fair value by 80%. Consequently, the compensation expense takes into account the expected number of options that are expected to vest. One of the ingredients of this adjustment is the estimation of the forfeiture rate for service conditions. Based on historical data of employees’ turnover, the company estimates the percentage of the beneficiaries that will leave the company before the vesting period lapses.

The total compensation expense is evenly allocated over the expected life of the award. For example, let us assume that a company reports its financial statements on an annual basis. If at the first reporting date the total compensation is estimated to be EUR 16 million and the vesting period of the award is four years, the yearly compensation expense to be recognized on this date would be EUR 4 million (= 16 million/4). The compensation expense allocated to the first year would be charged to the income statement and a corresponding increase in equity would be recognized, as follows:

At each subsequent reporting date, the adjustment due to non-market and service vesting conditions is re-estimated. Using our previous example, let us assume that the total compensation is revised at the second yearly reporting date to EUR 20 million from EUR 16 million. The yearly compensation expense to be allocated over the four-year vesting period becomes EUR 5 million (= 20 million/4). The compensation expense allocated to the second yearly period would be as follows:

Also, on the second reporting date an adjustment has to be made if the total compensation expense is revised due to changes in the estimation of the number of equity instruments expected to vest. This adjustment brings the already recognized compensation expense in line with the new total compensation estimate. As the company already recognized EUR 4 million expense at the first yearly reporting date, the company would need to make a EUR 1 million (= 5 million – 4 million) adjustment to bring it in line with the new EUR 5 million yearly compensation expense, as follows:

The accounting recognition at the remaining reporting dates is similar to the recognition outlined for the second yearly reporting date. Therefore, on a cumulative basis, no amount is recognized if the equity instruments granted do not vest because of a failure to satisfy non-market or service vesting conditions.

However, if an ESOP achieves the non-market and the service conditions but does not achieve the market or non-vesting conditions, the amount recognized in the ESOP reserve and as compensation expense is not reversed.

Accounting Entries at Settlement or at Expiry

At maturity of the ESOP or upon its exercise, the balance of the ESOP reserve is recycled to another account of the shareholders’ equity section. There are two scenarios we need to consider: (i) all (or part of) the plan options expire unexercised and (ii) all (or part of) the plan options are exercised.

Let us assume that all the beneficiaries behave identically and that by its maturity the ESOP has not been exercised. Let us assume that the ESOP reserve shows a balance of EUR 20 million. Therefore, a compensation expense of EUR 20 million should already have been recognized during the ESOP's expected life. It would be illogical to leave a balance on the ESOP reserve which relates to an ESOP that no longer exists. Therefore, the balance of the ESOP reserve is recycled to other account(s) of the shareholders’ equity section. The credit is usually taken to retained earnings but there is nothing to prohibit it from being credited to a separate equity reserve. The accounting entries in our example would be the following:

Upon exercise of the ESOP, there would also be a recycle within the shareholders’ equity section, but it has to be implemented in accordance with the action taken by the company. Upon exercise of the ESOP, the company has two alternatives: (i) to issue new shares or (ii) to deliver treasury shares.

Conclusions

If the non-market vesting conditions and the service conditions are satisfied while the ESOP's market and non-vesting conditions are met, the personnel expense is not reversed, and the total expense ends up increasing shareholders’ equity, even if the ESOP expires unexercised. Thus, if an ESOP has a market vesting condition or a non-vesting condition, the company might still recognize an expense even if that condition is not attained and the option does not vest.

By contrast, an ESOP subject only to a non-market vesting condition does not result in an expense if the condition is not met.

8.2.2 Accounting for Stock Appreciation Rights

As mentioned earlier, SARs plans – if exercised – are settled by paying to the beneficiary the intrinsic value of the underlying option in cash. The accounting recognition of cash-settled awards is covered next. The accounting recognition for awards in which either the beneficiary or the company can choose between settling the award in cash or in shares follows a similar procedure, except that if the physical settlement is elected on exercise date there is an additional accounting entry to recognize the delivery of the shares.

Required Actions on Grant Date

On grant date, no actions take place.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award is calculated (see Figure 8.5). The expense is measured by fair valuing the embedded equity option and adjusting it for the likelihood of achievement of all the vesting (market, non-market and service) and non-vesting conditions.

The total compensation expense is evenly allocated over the expected life of the award. For example, let us assume that a company reports its financial statements on an annual basis. If, at the first reporting date, the total compensation is estimated to be EUR 16 million and the expected life of the award is four years, the yearly compensation expense to be recognized on this date would be EUR 4 million (= 16 million/4). The compensation expense allocated to the first year would be charged to the income statement and a corresponding increase in liabilities would be recognized, as follows:

At each subsequent reporting date, the compensation expense would be re-estimated. Using our previous example, let us assume that the total compensation is revised at the second yearly reporting date to EUR 20 million from EUR 16 million. The yearly compensation expense to be allocated over the four-year expected life of the award becomes EUR 5 million (= 20 million/4). The compensation expense allocated to the second yearly period would be as follows:

Also, on the second reporting date an adjustment has to be made if the total compensation expense is revised due to changes in the estimation of the number of equity instruments expected to vest. This adjustment brings the already recognized compensation expense in line with the new total compensation estimate. As the company already recognized EUR 4 million expense at the first yearly reporting date, the company would need to make a EUR 1 million (= 5 million – 4 million) adjustment to bring it in line with the new EUR 5 million yearly compensation expense, as follows:

The accounting recognition at the remaining reporting dates is similar to the recognition outlined for the second yearly reporting date. Therefore, on a cumulative basis, no amount is recognized if the equity instruments granted do not vest because of a failure to satisfy market and/or non-market vesting conditions.

8.3 CASE STUDY: ABC'S ESOP AND SAR

8.3.1 Main Terms of ABC's ESOP and SAR

In order to illustrate the hedging and accounting of stock options plans and SARs, let us look at an example. Let us assume that ABC, a European company, on 1 January 20X1 granted two share-based plans, an ESOP and a SAR, with identical terms (except the settlement mode) to its top management. The main terms of the ESOP were the following (see Figure 8.6):

• Grant date: 1 January 20X1.
• Number of options: 2 million per plan (or 4 million options in total).
• Number of beneficiaries: 50.
• Exercise price: EUR 50.00 (ABC's stock price on grant date).
• Vesting period: From 1 January 20X1 to 31 December 20X3 (i.e., 3 years duration).
• Exercise period: At any time from 1 January 20X4 to 31 December 20X4.
• Settlement: Upon exercise, beneficiaries will receive one share per option and pay the strike amount (i.e., the number of options times the strike price).
• Market vesting conditions: ABC's stock total return, including dividends, has to outperform the EuroStoxx50 index.
• Service conditions: Each grant is conditional upon the beneficiary remaining in service over the vesting period.
• Non-market vesting conditions: Each grant is conditional upon ABC's EBITDA achieving a 10% annual growth rate during the vesting period.

Under the ESOP, if a beneficiary exercised his/her options, he/she would pay the exercise amount (i.e., the EUR 50.00 strike times the number of options exercised) and receive the options’ underlying ABC shares. The ESOP had a three-year vesting period. After completion of the vesting period, each beneficiary could exercise his/her vested options during the year commencing on the end date of the vesting period, subject to the achievement of three vesting conditions: (i) that ABC's stock price outperformed the European most liquid stock index; (ii) that the beneficiary remained an employee during the vesting period; and (iii) that during the vesting period ABC's EBITDA grew at least 10% annually.

Under the SAR, the mechanics were the same except its payoff upon exercise. If a beneficiary exercised his/her options, he/she would receive in cash the intrinsic value of the options. The intrinsic value of the options was defined as the difference between the value of ABC's stock at expiry and the EUR 50.00 award exercise price, for the number of options the beneficiary had exercised. Figure 8.7 depicts the SAR payoff as a function of the average stock price upon exercise.

8.3.2 Accounting for ABC's ESOP

In this section I will cover how ABC's ESOP plan was accounted for. In summary, the embedded equity stock option (including the market conditions) was fair valued only when the ESOP was granted. The compensation expense was calculated at each balance sheet date by adjusting the fair value of the embedded equity option for the likelihood of achievement of the non-market and service conditions. The total fair value was recognized as a personnel expense spread over the vesting period of the plan and an equity reserve.

Actions Required on Grant Date

On grant date, ABC estimated the fair value of the equity option, ignoring the non-market and service vesting conditions, but taking into account the non-vesting conditions (in this case there were no non-vesting conditions). Based on historical data, ABC estimated that on average the beneficiaries would exercise the fair value of the option at the end of the first six months of the exercise period (i.e., 3.5 years after the grant date). Thus, the best estimation of the expected life of the award was 3.5 years. The fair value of the equity option was calculated by pricing a call option on ABC stock with a strike of EUR 50.00 (i.e., at-the-money), an expiry of 3.5 years, a volatility equal to the implied volatility for such options on ABC stock and a 2% expected dividend yield of ABC stock during its life. The option valuation also included the market vesting condition (the outperformance of the EuroStoxx50 index), assuming a 60% correlation between ABC's stock price and the index. ABC used the Monte Carlo simulation method to estimate the fair value of this option, coming up with a EUR 21 million fair value. Beware that the fair value of the option did not include any estimates regarding the non-market and service conditions.

No accounting entries took place on grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award was calculated (see Figure 8.8). The expense was measured by adjusting the equity option fair value (that was calculated on the grant date) for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest. Based on historical data of employees’ turnover, ABC estimated the percentage of the beneficiaries expected to leave the company before the vesting period lapsed. Also, ABC estimated the likelihood of ABC's EBITDA achieving a 10% annual growth rate during the vesting period.

The total compensation (i.e., personnel) expense was evenly allocated over the three-year vesting period of the award. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.

On 31 December 20X1, ABC estimated the expected likelihood of meeting the non-market vesting conditions to be 80%. A EUR 16.8 million total compensation expense was calculated by multiplying the 80% estimation by the EUR 21 million equity option fair value. The compensation expense allocated to the first year was charged to the income statement and a corresponding increase in equity was recognized, as follows (amounts in EUR million):

On 31 December 20X2, the expected likelihood of meeting the non-market and service vesting conditions was re-estimated to be 70%. A EUR 14.7 million total compensation expense was calculated by multiplying the 70% estimation by the EUR 21 million equity option fair value. The compensation expense allocated to the second year was charged to the income statement and a corresponding increase in equity was recognized, as follows (amounts in EUR million):

Also on 31 December 20X2, a EUR 0.7 million adjustment to the compensation expense was implemented as the new annual expense was EUR 4.9 million while the personnel expense recognized on 31 December 20X1 was EUR 5.6 million. The adjustment was recorded as follows (amounts in EUR million):

Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):

Accounting Entries upon Exercise or Unexercised Expiry

At maturity of an ESOP or upon its exercise, the balance of the ESOP reserve was recycled to another account of the shareholders’ equity section. There are two scenarios to consider: (i) all (or part of) the plan options expired unexercised and (ii) all (or part of) the plan options were exercised.

In order to describe the accounting entries under the first scenario, let us assume that under ABC's ESOP all the beneficiaries behaved identically and upon the ESOP expiration on 31 December 20X4 it was not exercised. The ESOP reserve showed a balance of EUR 15.8 million. Therefore, a compensation expense of EUR 15.8 million had been recognized during the ESOP's vesting period. It would have been illogical to leave a balance on the ESOP reserve which related to an ESOP that no longer existed. Therefore, the balance of the ESOP reserve was recycled to other account(s) of the shareholders’ equity section. The credit was taken to retained earnings but it could have been credited to a separate equity reserve. The accounting entries were the following (amounts in EUR million):

Under the second scenario, exercise of the ESOP, there was also a recycle within the shareholders’ equity section, but the accounts affected depended on the action taken by the company. Upon exercise of the ESOP, the company had two alternatives: (i) to issue new shares or (ii) to deliver treasury shares.

Let us assume that the ESOP was exercised simultaneously by all the beneficiaries at the end of the fourth year and that ABC issued 2 million new shares, with a nominal value of EUR 2 million. Upon exercise of the ESOP the beneficiaries paid the EUR 100 million (= 2 million × 50.00) strike amount and received the new shares. The accounting entries were the following (amounts in EUR million):

If the company delivered treasury shares, the accounting entries were the following (amounts in EUR million), assuming that the treasury shares delivered were originally recognized at EUR 15 million:

Conclusions

If, at the end of the vesting period, the non-market condition (i.e., ABC's EBITDA 10% growth) was not achieved, a reversal of the ESOP's personnel expense already recognized would have taken place. Thus, on a cumulative basis no amount of personnel expense is recognized if the equity instruments granted do not vest because of a failure to satisfy non-market vesting conditions or service conditions.

If the non-market vesting conditions and the service conditions were satisfied while an ESOP's market and non-vesting conditions (in our case there were no non-vesting conditions) were met, the personnel expense would not be reversed, and the total expense would end up increasing shareholders’ equity, even if the ESOP expired unexercised. Thus, if an ESOP has a market vesting condition or a non-vesting condition, the company might still recognize an expense even if that condition is not attained and the option does not vest.

From the grant date ABC knew the maximum amount of compensation expense that it could end up recognizing in P&L. This maximum amount was the fair value of the equity option on grant date (i.e., EUR 21 million).

8.3.3 Accounting for ABC's SAR

In this subsection I will cover how ABC's SAR plan was accounted for. In summary, the whole award was fair valued periodically at each balance sheet date. The fair value was recognized as a personnel expense spread over the life of the plan and a liability.

Actions Required on Grant Date

No actions and no accounting entries took place on grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award was calculated (see Figure 8.9) by estimating the fair value of the embedded equity option expense and adjusting it for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest.

The total compensation (i.e., personnel) expense was evenly allocated over the three-year vesting period. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.

On 31 December 20X1, ABC estimated both (i) the fair value of the embedded equity option (EUR 20 million) and (ii) the expected likelihood of meeting the non-market and service vesting conditions (80%). A EUR 16 million total compensation expense was calculated by multiplying the 80% estimation by the EUR 20 million equity option fair value. The compensation expense allocated to the first year was charged to the income statement and a corresponding increase in liabilities was recognized, as follows (amounts in EUR million):

Repeating the process executed on the previous reporting date, on 31 December 20X2 ABC estimated a EUR 18.2 million compensation expense. Of this expense, EUR 6.1 million was allocated to the second year, being charged to the income statement and to liabilities, as follows (amounts in EUR million):

Also on 31 December 20X2, a EUR 0.8 million adjustment to the compensation expense was implemented as the new annual expense was EUR 6.1 million while the personnel expense recognized on 31 December 20X1 was EUR 5.3 million. The adjustment was recorded as follows (amounts in EUR million):

Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):

Accounting Entries upon Exercise or Unexercised Expiry

Let us assume that no beneficiaries exercised their rights prior to the SAR's expiry date. Let us assume further that at expiry, on 31 December 20X4, all the beneficiaries behaved identically. Then, there are two scenarios to consider: (i) all the SAR options expired unexercised and (ii) all the plan options were exercised.

Under the first scenario, the SAR lapsed fully unexercised. Thus, the SAR's fair value was zero. At the previous reporting dates a total EUR 21.8 million compensation expense was recognized. Therefore, this compensation expense had to be reversed on 31 December 20X4. The accounting entries were the following (amounts in EUR million):

Under the second scenario, the SAR was fully exercised. Let us assume that on 31 December 20X4 ABC's share price was EUR 68. The SAR's fair value was EUR 36 million [= 2 million × (68 – 50)]. As ABC had already recognized a total EUR 21.8 million compensation expense, an additional EUR 14.2 million (= 36 million – 21.8 million) expense was recognized, as follows (amounts in EUR million):

Additionally, the EUR 36 million cash award payment to the beneficiaries was recognized as follows (amounts in EUR million):

Conclusions

At each reporting date ABC had to fair value the SAR award. It had several implications:

• ABC's income statement was exposed to a rising stock price, potentially increasing its volatility.
• Overall, ABC did not have to recognize a compensation expense were the SAR to expire worthless.
• On grant date ABC did not know the maximum amount of compensation expense that it could end up recognizing in P&L. Similarly on grant date, ABC did not know the amount of cash it would need to meet the SAR award.

8.4 MAIN ESOP/SAR HEDGING STRATEGIES

In this section I will cover the main strategies (see Figure 8.10) to hedge ESOPs and SARs, using ABC's share awards.

8.4.1 Underlying Risks in ESOPs and SARs

One not unusual hedging strategy is to do nothing. ABC would be exposed to the risk inherent in the plans. The risks in an ESOP and in a SAR differ due to their accounting and settlement differences. Thus, hedging strategies for an ESOP may not work for a SAR, and vice versa.

Risks in an ESOP

ABC was not exposed to equity market risk. Remember that from an accounting perspective, under the ESOP the equity option is estimated at grant date. During the expected life of the award, the equity option is not fair valued. Only the expectations of meeting the non-market conditions are reassessed at each reporting date. Therefore, ABC's P&L was not exposed to changes in ABC's stock price or changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the EuroStoxx50 index). In other words, ABC's P&L was not exposed to equity risk. While ABC'S P&L was exposed to non-market risks, its hedge is usually not feasible.

ABC was exposed to dilution risk. If the ESOP ended up being exercised, ABC would need to deliver shares to the beneficiaries. Probably these shares would be newly issued, increasing the number of shares outstanding and, thus, diluting existing shareholders. However, the dilution risk was limited. New shares would be issued at EUR 50.00 per share.

Risks in a SAR

ABC was exposed to market risk. Remember that from an accounting perspective, under ESOP the equity option is fair valued at each reporting date. Therefore, ABC's P&L was exposed to changes in ABC's stock price or changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the EuroStoxx50 index).

ABC's P&L was exposed to the achievement of the non-market Conditions too. However, hedging these risks is usually not feasible.

ABC was also exposed to liquidity risk. Upon exercise, ABC would need to pay cash to the beneficiaries. A large amount of cash may require ABC to use precious liquidity resources or/and to raise financing.

ABC was not exposed to dilution risk as upon exercise no shares would be delivered to the beneficiaries.

8.4.2 Hedging with Treasury Shares

Hedging with treasury shares is, in my experience, the most common way to hedge ESOPs or SARs. In order to fully hedge the ESOP/SAR with treasury shares, on 1 January 20X1 ABC would need to acquire 4 million shares (2 million shares per plan) in the market, investing EUR 200 million. The treasury shares would be held in its balance sheet in coordination with the unexercised stock options. Each time that a beneficiary exercises his/her option rights:

• Related to the SAR, ABC would sell in the market the shares corresponding to the exercised options at the then prevailing share price. ABC would pay the beneficiary the intrinsic value of the exercised stock options.
• Related to the ESOP, ABC would deliver the shares to the beneficiary in exchange for the exercise amount.

At maturity of the plan, ABC would need to decide what to do with the remaining shares. In theory, ABC would sell the shares in the market, but it could keep them for future ESOPs/SARs.

This strategy can be optimized to take into account the likelihood of meeting the non-market conditions and the market conditions not directly related to ABC's stock price. As a result, ABC would acquire a number of shares equivalent to the number of the plans’ options expected to vest.

Strengths of the Strategy

The strategy has the following strengths:

• If the plan options are exercised, ABC would have effectively met the settlement commitments under both plans.
• Ignoring the financing costs related to the treasury shares, this hedging alternative is cheaper than hedging with calls if the plans are exercised. If the stock options are exercised, ABC would have saved the call premium, which can be substantial.
• The initial acquisition of the shares may have a positive effect on ABC's stock price.
• The hedge is not revalued during the life of the plan. Thus, there is a parallel accounting treatment in equity of the ESOP's embedded equity option and the treasury shares.

Weaknesses of the Strategy

The strategy has the following drawbacks:

• The acquisition of treasury shares uses resources from the company. ABC might need to raise financing to fund the own shares acquisition.
• The acquisition of treasury shares has a negative impact on the debt-to-equity ratio. Treasury shares are deducted from equity, increasing ABC's leverage.
• The hedge is not revalued. This is a weakness only for SARs. The SAR plan would be revalued periodically while the hedge will not be. As a result, ABC would experience a mismatch in P&L.
• At maturity of the plan the shares hedging unexercised options are not needed any more. ABC might sell the shares in the market at a price below acquisition price, permanently reducing equity.
• ABC does not receive the treasury shares dividends, as it cannot distribute dividends to its own shares.
• The acquisition of treasury shares may affect ABC's flexibility in managing its treasury shares. Legally, companies have a maximum limit (e.g., 10%) that sets the maximum percentage of voting capital that they can hold in own shares. Buying a substantial amount of treasury shares may bring the company close to the legal limit, restricting potential acquisition of more shares.
• Although the shares acquired to hedge a plan in theory should remain in the company's balance sheet until expiration, there is a potential temptation to manage these shares like the rest of the treasury shares. Some companies manage their holdings of treasury shares dynamically, to alleviate potential disruptions in stock market trading. For example, a company may acquire treasury shares to provide liquidity when there is a large selling order in the market and sell them later when its stock shows an undesirable strength.

8.4.3 Hedging with Equity Swaps

One relatively common hedging strategy is to enter into an equity swap. Due to their significantly different effects, I will separate the analysis for each type of plan.

Hedging an ESOP with an Equity Swap

Let us assume that ABC hedged its ESOP plan with an equity swap. The strategy is in a way similar to a combination of a financing and an acquisition of treasury shares. Let us assume that ABC entered into a total return equity swap with the following terms:

• Trade date: 1 January 20X1 (the plan's grant date).
• Termination date: 31 December 20X4.
• Number of shares: 2 million (the ESOP's number of options).
• Shares: ABC's common stock.
• Initial price: EUR 50.00 (ABC's stock price on trade date).
• Initial equity notional amount: EUR 100 million.
• Equity amount receiver: ABC.
• ABC can partially/totally terminate the equity swap early, at any time from 1 January 20X3 to 31 December 20X4.
• ABC pays quarterly Euribor-3m plus 150 bps on the equity notional amount.
• ABC receives 100% of the gross dividends paid to the underlying shares.
• Settlement: physical settlement only.

The strategy is executed as follows:

The equity swap would be treated for accounting purposes as an equity instrument. The initial accounting entry under IFRS would be (amounts in EUR millions) the following, assuming that EUR 86 million is the present value of the EUR 100 million equity notional:

The equity swap would not be fair valued during its life. As a result, the equity swap does not add volatility to the income statement as both the plan (ignoring service conditions) and the equity swap do not require fair valuing after the grant date. However, a liability would be recognized, increasing ABC's leverage metrics.

Hedging a SAR with an Equity Swap

Let us assume that ABC hedged its SAR plan with an equity swap. The terms would be identical to the equity swap traded to hedge the ESOP, except its settlement terms. This equity swap allowed for cash settlement only. Therefore, at each partial early termination and/or at maturity:

• ABC would receive, if ABC's stock price is greater than EUR 50.00:
  
• ABC would pay, if ABC's stock price is lower than EUR 50.00:
  

Figure 8.11 shows the equity swap settlement amount as a function of the average final price. It can be seen that if the average final price was greater than EUR 50.00, and ignoring the SAR's service conditions, ABC would have perfectly hedged its commitment under the SAR. However, if the average final price was lower than EUR 50.00, ABC could lose a substantial amount.

The strategy is executed as follows:

The equity swap would be treated for accounting purposes as a derivative. It is unlikely that ABC would be able to apply hedge accounting as the payoffs of the SAR (a call option) and the equity swap were very different when ABC's stock price was below EUR 50.00. As a result, the equity swap would be fair valued through P&L at each reporting date. Remember that the SAR would also be fair valued at each reporting date, but the change in fair value would be allocated over the vesting period. Therefore:

• If ABC's share price is greater than 50.00, the change in fair value of the SAR and the equity swap would be similar (ignoring the time value of the equity option underlying the SAR and the adjustments due to the service condition). However, there would be an accounting mismatch in P&L, as the whole change in fair value of the swap would be recognized in P&L while one-third of the change in fair value of the SAR would be recognized in P&L.
• If ABC's share price is lower than 50.00, the change in fair value of the equity swap would be notably different from that of the SAR. To make things worse, only one-third of the change in fair value of the SAR would be recognized in P&L. As a result, a substantial mismatch in P&L could result, potentially increasing the volatility of ABC's income statement.

In summary, this hedging strategy could end up creating substantial distortions in ABC's financial statements. In the next subsection I will cover a more friendly variation of the equity swap.

Strengths of the Strategy

The strategy has the following strengths:

• If the plan options were exercised, ABC would have effectively met the settlement commitments under both plans.
• ABC was not using cash resources, in contrast to a hedge with treasury shares.
• Ignoring the financing costs related to the equity swap, this hedging alternative was cheaper than hedging with calls if the plans were exercised. If the awards’ options were exercised, ABC would have saved the call premium, which was substantial.
• The bank counterparty to the equity swap needed to buy the underlying shares in the market at inception. This initial acquisition had a positive effect on ABC's stock price.
• Regarding the ESOP, the hedge was not revalued during the life of the plan. Thus, there was a similar accounting treatment in equity of the ESOP's embedded equity option and the treasury shares.

Weaknesses of the Strategy

The strategy has the following drawbacks:

• If the plans were unexercised because ABC shares were trading below EUR 50.00, ABC would either end up with unwanted treasury shares (in case of the ESOP) or with a loss (in case of the SAR).
• Regarding the SAR, if the shares were trading below EUR 50.00, there could be a substantial increase in the volatility of ABC's income statement due to the accounting recognition mismatch in P&L between the equity swap and the SAR.
• Regarding the ESOP, the equity swap had a double-negative effect on ABC's leverage metrics – for example, on its debt-to-equity ratio. On the one hand, there was a liability recognized from inception. On the other hand, there was an equity entry that reduced the balance of the shareholders’ equity section of ABC's balance sheet.
• The equity swap consumed credit lines with its counterparty, reducing its flexibility to deal with this party.
• In some jurisdictions, an equity swap may be treated as treasury shares from a legal perspective. This may affect ABC's flexibility in managing its treasury shares, as they are usually subject to a maximum legal limit.

8.4.4 Hedging a SAR with an Enhanced Equity Swap

As we saw in the previous subsection, hedging a SAR with an equity swap can create substantial distortions in ABC's financial statements, especially in P&L. In this subsection I will cover a more friendly variation of the equity swap.

A long position in an equity swap can be viewed as the combination of a purchased call option and a sold put option, with a strike equal to the reference price (see Figure 8.12).

In our case, ABC would buy a call option and sell a put option with the following common terms to hedge the SAR:

• Trade date: 1 January 20X1 (the plan's grant date).
• Counterparties: ABC and Gigabank.
• Number of options: 2 million.
• Shares: ABC's common stock.
• Exercise price: EUR 50.00 (ABC's stock price on trade date).
• Exercise period: At any time from 1 January 20X3 to 31 December 20X4.
• Partial exercise: The buyer can partially/totally exercise the options during the exercise period.
• Settlement: Cash settlement only.
• Additional condition: The option can only be exercised if ABC's stock total return (i.e., including dividend reinvestment) has outperformed the EuroStoxx50 index from trade date to 31 December 20X2.
• Upfront premium: EUR 21 million (i.e., 21% of ABC's stock price on trade date), to be paid two currency business days following the trade date.
• Dividends: Gigabank will pay ABC an amount equal to the delta times the gross dividends distributed to the underlying shares.

Now, from an accounting point of view, ABC could apply hedge accounting for the call option. As a result, the change in the fair value of the SAR (excluding the effect of the service conditions) and that of the call option, after being both allocated to the vesting period, would cancel each other in P&L. The put would be recognized as a speculative derivative, and therefore, the full change in its fair value would be recognized in P&L. This way, the accounting mismatch between the SAR and its hedge would be caused only by the put. For example, if the put became deeper out-of-the-money, the accounting mismatch would gradually disappear.

8.4.5 Hedging with Standard Call Options

One relatively uncommon hedging strategy is to acquire from a bank a call option that perfectly mirrors the equity option embedded in an ESOP/SAR plan. Therefore, ABC would buy call options with the following terms:

• Trade date: 1 January 20X1 (the plan's grant date).
• Number of options: 4 million (2 million per plan).
• Buyer: ABC.
• Shares: ABC's common stock.
• Exercise price: EUR 50.00 (ABC's stock price on trade date).
• Exercise period: At any time from 1 January 20X3 to 31 December 20X4.
• Partial exercise: ABC can partially/totally exercise the options during the exercise period.
• Settlement: For 2 million options (i.e., those hedging the ESOP), physical settlement only. For the remaining 2 million options (i.e., those hedging the SAR), cash settlement only.
• Additional condition: The options could only be exercised if ABC's stock total return (i.e., including dividend reinvestment) has outperformed the EuroStoxx50 index from trade date to 31 December 20X2.
• Upfront premium: EUR 42 million (i.e., 21% of ABC's stock price on trade date), to be paid two currency business days following the trade date.

The strategy is executed as follows:

As we can see, the exercises under the plans are perfectly hedged by the call options exercises. From an accounting point of view:

• Due to their physical settlement term, the call options hedging the ESOP plan would be recognized in equity and no fair valuing during their life would be required. Therefore, the hedge would have no impact in P&L. Remember, however, that the potential effects on P&L volatility due to non-market vesting conditions remain unchanged.
• Regarding the call options hedging the SAR plan, ABC would need to apply hedge accounting in order to minimize any mismatch with the plan's accounting recognition. Therefore, the hedge would eliminate the plan's impact in P&L due to market vesting conditions. Remember, however, that the potential effects on P&L volatility due to non-market vesting conditions remain unchanged.

Strengths of the Strategy

The strategy has the following strengths:

• If the plan options are exercised, ABC would have effectively met the settlement commitments under both plans.
• ABC is not exposed to a share price lower than the strike price.
• In the case of the SAR, the hedge eliminates the plan's P&L impact due to market conditions as ABC is able to apply hedge accounting.
• The accounting treatment of the hedge is similar to that of the plans, not creating accounting distortions.
• The implementation of the hedge may have a positive effect on ABC's stock price as the bank supplying the call options needs to acquire ABC shares in the market at inception.
• ABC may sell the options at the end of the vesting period if the non-market conditions are not achieved. The sale would effectively reduce the hedge cost.

Weaknesses of the Strategy

The strategy has the following drawbacks:

• ABC needs to pay a substantial premium upfront, as the ESOP/SAR have long-term maturities, using resources from the company. ABC might need to raise financing to fund the premium. However, the premium is notably lower than the initial outflow when hedging the plans with treasury shares.
• The acquisition of a call has a negative impact on the debt-to-equity ratio. The premium is deducted from equity, increasing ABC's leverage. However, the effect on leverage is notably lower than the effect when hedging the plans with treasury shares.

8.4.6 Hedging with Auto Call Options

The main weakness of hedging a plan with a call option is the premium to be paid. As ESOPs/SARs have typically long-term expiries, a call option on a highly volatile stock can be prohibitively expensive. Optimally, the ESOP/SAR beneficiaries would exercise their options at the end of the expiry date (assuming no large special dividends are distributed to the underlying shares). However, if an ESOP/SAR beneficiary is exercised before the award final expiry date, this obliges the sponsoring company to exercise its hedging call option early, foregoing the call option's time value. Let us assume that ABC looked at past patterns of beneficiary exercise behavior and estimated that the percentage of the ESOP/SAR options that would be exercised at the start of the exercise period followed a straight line, as shown in Figure 8.13.

One way to lower the premium of a hedging call option is to incorporate the expected beneficiaries’ early exercise pattern in the terms of the option. This option is often referred to as an “auto call option” or a “call option with an automatic early exercise”. The terms of the auto call would be identical to those of the call detailed earlier, except that one new term would be included. The term would be defined as follows:

• Automatic early exercise: If, on the first date of the exercise period, ABC's stock closing price (X) is greater than EUR 50.00, the following number of options will be exercised on this date:

If the exercise period is long (e.g., 3 years), an auto call option can be notably cheaper than a standard option. Of course, ABC would be running the risk that the beneficiaries do not behave as planned.

8.4.7 Hedging with Timer Call Options

Imagine that ABC was looking at hedging its plans with a call option at a time during which volatilities were sky high. When quoting the call option, banks were pricing a 50% implied volatility (a volatility much larger than ABC's 30% long-term historical volatility), resulting in a EUR 35 million premium per plan. ABC believed that the realized volatility of such an option would be much lower than the implied volatility the market was pricing. Instead of acquiring the standard call option, ABC decided to purchase a timer call (see Chapter 5 for a description of timer puts). The terms of the timer call would be identical to those of the standard call, except that one new term would be included. The term would be defined as follows:

• Rebate = two currency business days after the first exercise date. The “rebate payer” will pay to the “rebate receiver” the “rebate amount”, as shown in the following table (the rebate amount will be linearly interpolated using the two closest realized volatility levels):

Therefore, if the realized volatility (see the timer puts description in Chapter 5 for the definition of realized volatility) from trade date up to the first exercise period was 30%, ABC would receive a EUR 14 million rebate. Taking into account the initial EUR 35 million premium and ignoring the time value of money, ABC would have paid EUR 21 million (= 35 million – 14 million) for the option. On the contrary, if the realized volatility was 60%, ABC would pay a EUR 7 million rebate. Taking into account the initial EUR 35 million premium and ignoring the time value of money, ABC would have paid EUR 42 million (= 35 million + 7 million).

8.5 HSBC'S PERFORMANCE SHARE PLAN

In this section I will review a highly structured share plan awarded by HSBC. Similar plans were awarded by UBS and Banco Santander. The hedging of this type of plan is very complex, and I will explain why.

8.5.1 Terms of HSBC's Performance Share Plan

In 2007 HSBC awarded a deferred share-based variable remuneration which was payable in shares of the bank. The plan had a 3-year term. The award was divided into two parts. The number of shares to be delivered under the first half was defined by comparing HSBC's total shareholder return (TSR) with that of a benchmark group of 28 financial institutions. The number of shares to be delivered under the second half was subject to achieving a target earnings per share (EPS). The plan also included service vesting conditions, such as the beneficiary being employed during the vesting period.

• Total shareholder return (TSR) measured the total return of a stock, i.e. both the dividend yield and the capital appreciation of the share price. TSR was calculated by assuming that (a) someone bought the share at the start of the vesting period, (b) any dividends received on the share had been used to buy more shares when received, and (c) the shares (plus dividend shares) were sold at the end of the vesting period. For example, if no dividends were paid and the share price increased from CU100 to CU107 after one year, the TSR would be 7%.

At the date of grant, a peer group of 28 banks was selected among the members of the Dow Jones Banks Titans 30, an index comprising the top 30 companies by market capitalization in the banking sector. Also, on grant date, a maximum number of shares were established for each beneficiary. One half of the award was subject to the TSR measure and the other half was subject to an EPS target. I will hereafter only consider the TSR element of the award, to focus the analysis.

At the end of the vesting period, the TSR of each bank (including HSBC) during the vesting period was calculated. The TSRs were ranked from first to last. The shares assigned to the TSR measure were released to the beneficiary on a sliding scale from 30% to 100% in accordance with HSBC's position among the group of benchmark financial institutions, providing that HSBC's place in the ranking was not below the top 19th TSR. Figure 8.14 depicts the number of shares delivered to a beneficiary, assuming 100 shares were initially awarded to the beneficiary. Therefore, the beneficiary received the maximum of shares only if HSBC fared first in the TSR ranking.

8.5.2 Accounting for the Plan

The accounting for the plan followed the rules we covered earlier for the ESOP. In this case, the TSR ranking profile was a market condition, as all the variables were related to a financial market. Thus, at the date of grant HSBC estimated the fair value of the embedded option using the Monte Carlo method, incorporating the TSR performance target. This fair value was not remeasured during the vesting period.

At each reporting date, the likelihood of achievement of the service conditions was estimated. The personnel costs were calculated by multiplying the fair value of the equity option by this estimation. The personnel costs were allocated over the vesting period, with a credit to equity.

At the end of the vesting period, HSBC issued new shares to meet the award. The equity recognized during the vesting period was then recycled to the “common stock” and “additional paid-in capital” accounts.

8.5.3 Hedging the Plan

The hedging of the plan is quite complex. Let us assume that to hedge the position HSBC buys the underlying equity option from Gigabank. Gigabank would then need to dynamically hedge its position. This option is an outperformance option; the more banking stocks that HSBC shares outperform, the larger the number of shares that Gigabank would need to deliver to HSBC. On trade date:

• Gigabank bought shares of HSBC.
• Gigabank sold shares of the 28 benchmark financial institutions. Therefore, Gigabank needed to borrow shares of the 28 stocks for 3 years. Fortunately, this group of banks was large and liquid, with an active stock lending market.
• Gigabank had to estimate the volatility of each stock and the correlation between each pair of stocks (including HSBC).
• Gigabank needed to hedge the FX risk. Most of the 28 benchmark banking stocks were denominated in a currency other than GBP. Gigabank sold the foreign currencies and acquired GBP.

The main challenge of hedging this option was to manage the discontinuity around the 19th place in the ranking. Imagine that the option approached its expiry date (i.e., 3 years after its trade date) and HSBC's position in the ranking moved from the 20th to the 19th place. Suddenly, the number of shares to be delivered varied from zero to 30% of the maximum. The hedge would jump in accordance with the shares to be delivered, making Gigabank acquire 30% of the maximum HSBC shares. If HSBC's stock moved back to the 20th place in the ranking, Gigabank would need to sell back the shares onto the market. Due to this large gap, Gigabank could incur substantial losses when buying and subsequently selling. As a result, Gigabank charged HSBC a premium that took into account this risk.

What HSBC should have done is to design a plan with a friendlier hedging profile. For example, as shown in Figure 8.15, it could eliminate the discontinuity by extending the straight line to reach a point at which no shares are delivered. Gigabank would have priced the option more aggressively. Also, the fair value of the plan's equity option would have diminished, lowering the compensation cost to be recognized.

Another drawback of the plan is the mismatch created in P&L if HSBC hedged the plan with the mirror option from Gigabank. Remember that HSBC did not fair value the plan's underlying equity option at each reporting date. Due to the potential delivery of shares at maturity, the counter-entry to the personnel expense was an equity entry. The only changes in compensation expense were due to changes in the expectations of attainment of the service conditions, typically a small variation. However, the change in fair value of the mirror option from Gigabank was recognized in the P&L, as HSBC was not able to apply hedge accounting. As a result, there was a recognition mismatch in P&L, potentially increasing the volatility of HSBC's income statement.

This strategy can be improved by taking into account the likelihood of meeting the service conditions. As a result, ABC would acquire from Gigabank a number of options equivalent to the number of plan options expected to vest.

Alternative Hedging Strategy

The acquisition of such a highly structured option can be very expensive. One alternative would be to hedge the plan with treasury shares. On grant date, ABC would acquire a number of treasury shares equal to the number of the plans’ options expected to vest. ABC would then adjust the number of treasury shares to incorporate any changes in its expectation regarding the vesting of the plan options.