Can anyone explain this quote from the material? I see this being a PERFECT test question that can be so easy if you know the answer, but an annoying one if you don’t. “With stock appreciation rights, employees have limited downside risk and unlimited upside potential, thereby limiting the risk aversion problem discussed earlier.” Issue with the quote also is Schweser didn’t discuss a risk aversion problem easier. Don’t even know what it’s referring to. I think it’s trying to draw a contrast between Stock Grant/Options VS Appreication Rights. Anyone?
It’s drawing comparison to incentives that have full downside. If you can loose lots of money, you may be more risk averse. If there is a floor so to speak, you will take more risk. Stocks have no 'floor" except 0.
Okay…not sure you were so clear there.
Please explain the Downside/Upside Risk to Management for
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Stock Option
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Stock Grant
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Stock Appreciation Right
I believe 1 and 2 are the same…as seen in a 2013 CFA mock. Stock Appreciation right has a different downside/Upside risk exposure. Why?
Bumpity Bump Bump Bump
stock option = right to buy the stock
stock appreciation rights = acts like a stock option but you get cashflows when excercised instead of the stock
this is advantageous with regards to it doesnt dilute the stockholders equity, but it is affects future cashflows. with stock options you can expense it over its vesting period, but with stock appreciation rights its quite undeterminable because you do not know future stock price and hence future cashflow payments.
both have limited down side as no payments or excersiing options happen if stock goes down
stock grant = you actually have the stock and bear downside risk.
you are welcome
oh with risk aversion
stock grants you are more risk averse because of the downside and volatily of prices that you dont want
stockoptions and appreciation rights you are more of a risk taker because there is no downside risk, you may do whatever you can to bring stock up = riskier
Stock Option : Employee has the right to buy the stock at a predetermined strike price. If the stock price is above the strike on the expiration date, the employee will likely exercise the option and pay the strike price for the stock. If the stock price is below the strike on the expiration, the employee will likely not exercise the option, and let it expire worthless.
The upside is that if the stock appreciates, the employee can profit from that appreciation. The downsides are that the employee has to pay the strike price (so the employee needs available cash), and, afterward, the employee owns stock that can drop in value. Also, when the employee exercises the option, the ownership for others in the company is diluted.
Stock Grant : The company gives stock to the employee.
The upside is that if the stock appreciates, the employee will profit from that appreciation. The downsides are the if the stock depreciates, the employee will lose from that depreciation. Also, others’ ownership in the company is diluted.
Stock Appreciation Right : The company agrees to pay (in some form) the employee if the stock price exceeds a given threshold.
The upside is that if the stock appreciates sufficiently, the employee will profit from that appreciation. And because the employee is not receiving sahres of stock, he doesn’t have to pay a strike price (no cash outlay), and the ownership of other shareholders isn’t diluted. The only downside is that if the stock doesn’t appreciate sufficiently, the employee gains nothing.
Hmmm…CFAI Mock says "1. Management will have the same downside risk exposure from the stock awards plan as they currently face with the stock options plan. " The downside risk is the same under both plans– namely, zero. Management is not penalized if the share price falls or if the accounting metrics are missed; they simply don’t receive a bonus.
Okay - thanks guys, think the issue is that while one may think Stock Grant is is as S2000Magician said, it’s not really always the case. For e.g in the 2013 Mock, stock grant was tied to accounting metrics, so again downside is Zero.
In a case where a question specifically says stocks are Automatically granted to the Company, then there is downside risk. I think otherwise you assume none/limited downside risk.