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Lecture 3: Equity Derivatives

Alonso Pea, SDA Professor


Banking and Insurance Department
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CASE STUDY

Dell Share Repurchase*

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.

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

Dell Share Repurchase

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.

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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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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CASE STUDY

Dell Share Repurchase

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.

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