L3_EQUITY_2011

Copyright SDA Bocconi, protocollo xxxx

Lecture 3: Equity Derivatives

Alonso Peña, SDA Professor

Banking and Insurance Department

Copyright SDA Bocconi, protocollo xxxx 2 2

Carolyn Evans, a research analyst at LV Technology Fund, looked

up from Dell Computer's fiscal 1996 annual report to ponder

some news contained therein. Dell Computer, a company in

which the fund held a small investment, had recently (February

16, 1996) announced financial results for its fourth quarter, 1996

(quarter ending January 28,1996).

As part of this announcement, Dell had revealed that its board of

directors had authorized a stock repurchase program for up

to 12 million shares. The announcement also stated that Dell

might use equity options as part of the repurchase program.

CASE STUDY Dell Share Repurchase*

*These selections are from: George Chacko, Vincent Dessain, Peter Hecht, Anders Sjoman, Financial Instruments and Markets: A Casebook, Wiley, 2006. Chapter 17.


This statement brought back memories of 1993, Carolyn's first

year with the fund. At that time Dell, under attack by securities

analysts for its use of foreign exchange options for speculation,

had seen its stock price plunge from $49 per share to $16.

Now, on March 29, 1996, Carolyn got a glimpse of the types of

option transactions that Dell was undertaking. According to the

annual report, by late March 1996, Dell had already written 2.8

million put options and brought a similar number of call

options on its own stock. Carolyn was trying to understand

why Dell was using options and what effect they might have on

Dell's stock price.

CASE STUDY Dell Share Repurchase


Following the standard practice in the industry, Dell regularly

included stock options as part of its executive

compensation plan. Incentive awards were not limited

exclusively to stock options.

They could also include stock appreciation rights as well as

stock and cash. By granting stock options, Dell sought to

motivate and reward executives for maximizing stockholder

value and to encourage the long-term employment of key

employees.



The company's Incentive Plan provided for an aggregate of

17 million shares of common stock to be issued to

compensate employees.

At the end of fiscal year 1996 (January 28,1996), 8.48

million shares of common stock remained available for

future issuance under the Incentive Plan awards. At that time,

the company had a approximately 93.5 million shares

outstanding.



Stock options were usually granted with an exercise

price equal to the market value of Dell's common stock at

the time the options were issued, and they could not be

exercised immediately after issuance.

A fraction of the stock options granted in a given year was

usual exercisable one year after issuance, with the rest of

the options becoming exercisable in subsequent years.



On February 22, 1996, Dell announced that it had been

authorized by its board of directors to begin a stock

repurchase program that would allow the company to

provide shares to employees under the company's long-term

incentive, employee stock purchase, and retirement plans.

The board of directors authorized Dell to buy up to 12

million shares of its common stock through open market

or private transactions. It also authorized Dell to use equity

options as part of the repurchase program. The purchases

had to be funded from available working capital.



The Annual Report that Dell filed with the SEC at the end of

March 1996 reflected that, as of March 22, 1996, the

company had purchased a total of 3.3 million shares of

common stock in open market transactions for $100

million under the repurchase program.

In addition, the company had sold 2.8 million put options

and had purchased 2.8 million call options on Dell's

common stock under the same program.



The put exercise prices ranged from $29.36 to $34.62 per

share, while the call exercise prices ranged from $32.30 to

$38.09 per share.

These options were exercisable only at expiration, and the

expiration dates ranged from September 3, 1996 to

September 20, 1996.



As Carolyn walked to a meeting with the portfolio manager of

the fund, she wondered why Dell had chosen to utilize call

and put options as part of its share repurchase program.

From her basic knowledge on options, she knew options

could be effective hedging instruments. But she also knew

that they could be regarded simply as levered positions in the

underlying equity.



Were the options a way for Dell's management to make a

strong statement regarding what they felt to be an

undervaluation of Dell's shares, or were these options being

used to hedge some sort of risk?

She didn't know but she would have to come up with a

recommendation soon for the fund manager.


L3_EQUITY_2011

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