You have taken a management position in Ocean Cuisines plc that just went public last year. The company’s restaurants specialize in seafood dishes. A concern you had was that the restaurant business is risky.
During your interview process, one of the benefits you heard was employee stock option. Upon signing your employment contract, you obtained options with a strike price of £65 for 10,000 shares of company stock. As is fairly common, your stock options have a three-year vesting period and a 10-year expiration, meaning that you cannot exercise the options for a period of three years and you lose them if you leave before they vest. So your employee stock options are European for the first three years and American afterward. You cannot sell the option nor can you enter into any sort of hedging. Ocean Cuisines is currently trading at £40 per share, a slight increase from the initial offering price last year. You estimated that the annual average standard deviation for restaurant company stock is 20 percent. Since Ocean Cuisines is a new restaurant chain you decide to use a 25percent standard deviation in your calculations. You expect no dividends will be paid for the next 10 years. A three-year Treasury note currently has a yield of 3.4% and 10 year Treasury note has an yield of 6%.
Suppose that in three years, company’s stock is trading at £55. At that time, should you keep the options or exercise immediately? What are some of the important determinants in making such a decision?