# Geoff Considine, Ph.D.

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1 Google Employee Stock Options: A Case Study Geoff Considine, Ph.D. Copyright Quantext, Inc

4 4. Time to expiration 5. Risk-free rate of return 6. Dividend yield Because Google does not pay a dividend, we don t need to worry about number six so it comes down to five factors. The risk-free rate of return is easy to get you can use shortterm T-bill yield. We all know the current stock price and the employee knows the strike price of his/her option and the expiration date. Now comes the hard part. Since a great deal of the value of a call option is the probability that the price will go up, the future volatility of the stock is very important in valuing the option. There is a standard way to get a projection of the future volatility in a stock. What you do is to look at the prices at which options are trading in the public market: In this case, the link is to options on Google that expire in January 2009 on January 16, 2009, to be exact. You can take these options prices (their current market value) at a range of strikes and we know all of the items in the list above except for the volatility. Then we can simply calculate the volatility that allows our option pricing model to match the options prices in the market. You are essentially backing the volatility out of the market data and this is called the implied volatility. This is a standard variable that anyone who has ever taken a finance course will learn. There are financial calculators that will spit out implied volatility and E*Trade even has tools that will calculate implied volatility for you. How hard is this? Actually it s easy. Quantext Portfolio Planner (QPP) makes this functionality simple. I grabbed call option quotes for three expiration dates and calibrated QPP to provide similar option values: 4

5 Value of Call Option with \$470 Strike. \$100 \$90 \$80 \$70 \$60 \$50 \$40 \$30 \$20 \$10 \$0 January 2009 Option January 2008 Option June 2007 Option QPP Call Option Value Market Quote QPP-calculated value of call options vs. market quote on April 3, QPP uses a single value of volatility over time. Even given that strong assumption, QPP matches the market prices of the call options very closely. Let s focus on the January 2009 option. As stated, this option actually expires on January 16, The current market value for this option is about \$93. The intrinsic value is only \$1 (\$ ) but the total value is about \$93, so the extrinsic value is \$92. The time until expiration is about 1.9 years close to the maximum that options will index to if you sell the option in the Google auction. The QPP option valuation matches the current market quotes very closely for these three time periods, which tells us that we have calibrated our volatility estimate to be in line with the market. We have calculated the implied volatility in the options market for Google stock, so we can now look at varying other parameters. You can now vary things like the strike price and time to expiration to value your specific options. I have read that Google expects that the average lifetime of its options grants to employees is about four years. Let s say that you are Joe average and you are likely to 5

9 Quantext Portfolio Planner is a Monte Carlo portfolio management tool. Extensive case studies, as well as access to a free extended trial, are available at 9

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