Esoteric Finance Corner: Calculating the value of the embedded call on ESPP stock

Delta hedging in the goon cave

The US tax code allows for a tax-advantaged way for publicly traded companies to throw a little bit of extra cash at employees via below-market purchases of stock - these are called ESPP (Employee Stock Purchase Plan) programs.

A typical example will have a six month “plan period”, in which you can commit up to 10% of your paycheck to the purchase of company stock. The advantage comes from discount and lookback provisions: at the end of the six month period, typically you can buy stock at, say, a 10% discount to the lower of the start or end prices.

So if one works for AlphaSoft making $100K/year, which is to say $50K per plan period, the stock starts at $100/share, and rises to $120/share at the end of the period, one may purchase $5K of stock at $90/share. When you sell, there is somewhat exotic tax treatment of the discount and price appreciation components that depends on the holding period, but let’s for now focus on the pre-tax story.

Astute readers may notice that this amounts to an option to buy stock at a certain price - namely a 10% discount to the starting stock price. This is also known as a call option. In the example, your employer is effectively giving you a call option on 55 shares of the stock at $90/share.

What is interesting is that this call has a value associated with it that is not obvious at first glance, and it might be more to your benefit to split and sell the implicit call than to hang onto it. Instead of a toy example, let’s consider Microsoft.