OPTION PROBLEM -- CAN IT BE HEDGED?

The problem I will outline in this memo is one that I had originally wanted to do my project on. Unfortunately, I was limited on the books I could find about the topic and my lack of complex math skills. I write this to solicit your help. Perhaps in your reading on the subject of derivatives and hedging strategies you have come across something that may help me solve my "hypothetical" scenario. If so, please email me at akinter@trinity.edu. I would appreciate this so that I can stop thinking about how to solve the scenario.

The Scenario ---

Company XYZ wants to issue 1,000 options to their "key" employees to vest over the next five years. They are willing to recognize these options at their fair market value and therefore comply with FAS #123 Accounting for Stock Options. However, at the time the options are granted to the employees, the exercise price is not equal to the current market price. This inequality is much different than the current stock option awards that most company's use, as they usually set market price equal to stock option price on the date the options are granted. This election allows no compensation expense to be recognized according to APB #25. XYZ's philosophy behind awarding an option with an exercise price higher than the current market price is to encourage employees to increase the stock price so that their options value grow to be "in the money." The company feels that granting an option that is "in the money" at the time it is awarded is not incentive enough.

Possible Hedging Strategy ---

XYZ's current agreement with their board of outside directors and shareholders does not allow them issue additional shares of stock. They currently have 10,000 shares authorized and have 10,000 shares outstanding. Therefore, to the deliver the stock to the employees when they exercise their options, the company will have to go out into the market and purchase their own shares of stock. What they would like to do is to hedge against this possible purchase (liability).

What I Looked AT --

I thought it would be possible that a strategy could be created using an Asian option that was based on the average value of these granted options. (It would be more economical for the company.) This option strategy I believe should work, but I could not find a textbook or web page that illustrated how to value an option that was based on a moving average. This type of option does exist according Don Chance author of Introduction to Derivatives.

Interesting Accounting Issues This would Create

According to FAS #123, the options granted to employees are compensation and therefore should be recorded at their fair value at time of issuance. This fair value is recognized as an expense as the options vest. The options granted are not allowed to be revalued.

However, if a company was using a strategy to hedge against the average value of those options the current Exposure Draft issued by the FASB Accounting for Derivative and Similar Financial Instruments and for Hedging Activities would require that both the "asset" (the Asian option hedge) and the "liability" (the employee stock options) would have to be revalued at the company's year end with adjusting gains and losses recognized in the current period. (Like a Fair Value Hedge).

Do you see the inherent problem? Can a company revalue the employee options when FAS #123 says that are not supposed to be revalued? But according to the Exposure Draft, they would need to be to be in compliance with the new derivative standard. Additionally, the company would have to be recognizing a 20% compensation expense related to the awarded options each year.

Please note: Brandon Lamb did his project on Asian Options.

Info on FAS 123