CEP Risk Assessment & Underwriting 2 — Questions and Answers
Question 1: A company is evaluating whether to allow early exercise of employee stock options. Which risk is MOST directly introduced by permitting early exercise?
- Dilution risk from immediate share issuance (Correct answer)
- Interest rate risk on the option premium
- Counterparty default risk
- Regulatory compliance risk under Section 16
Correct answer: Dilution risk from immediate share issuance
Early exercise causes immediate share issuance, increasing outstanding shares and diluting existing shareholders sooner than anticipated.
Question 2: Under Black-Scholes option pricing, which input has the GREATEST sensitivity impact on an at-the-money option's value when the option has a long time to expiration?
- Dividend yield
- Strike price
- Volatility (Correct answer)
- Risk-free interest rate
Correct answer: Volatility
For long-dated at-the-money options, volatility (vega) typically has the greatest sensitivity impact on option value.
Question 3: A company conducting a tender offer for underwater stock options must consider which primary underwriting risk?
- The risk that employees accept at a higher rate than modeled (Correct answer)
- Currency exchange risk on the option proceeds
- The risk that the SEC rejects the tender offer pricing
- Reputational risk from employee dissatisfaction
Correct answer: The risk that employees accept at a higher rate than modeled
If acceptance rates exceed projections, the company faces higher-than-budgeted cash outflows or share usage to fund the offer.
Question 4: Which of the following BEST describes 'concentration risk' in the context of an employee equity plan?
- Risk that equity awards are concentrated among too few senior executives (Correct answer)
- Risk that the plan administrator holds too many shares in custody
- Risk that vesting schedules are all cliff-based
- Risk that equity awards are denominated in a single currency
Correct answer: Risk that equity awards are concentrated among too few senior executives
Concentration risk arises when equity compensation is heavily weighted toward a small group, creating governance and retention exposure if those individuals leave.
Question 5: An ESPP with a lookback provision and 15% discount exposes the company to which type of accounting risk?
- Risk of misclassifying the plan as non-compensatory under ASC 718
- Risk of understating the compensation expense due to the lookback feature (Correct answer)
- Risk of overstating earnings per share
- Risk of triggering Section 409A penalties
Correct answer: Risk of understating the compensation expense due to the lookback feature
The lookback feature is a compensatory element that increases the grant-date fair value and must be fully expensed; failure to capture it understates compensation cost.
Question 6: When assessing forfeiture risk for an equity plan, which data source is MOST reliable for estimating future forfeitures?
- Industry peer surveys on voluntary turnover
- The company's own historical forfeiture experience by employee group (Correct answer)
- Current macroeconomic unemployment rates
- The plan administrator's default assumption tables
Correct answer: The company's own historical forfeiture experience by employee group
ASC 718 requires entities to use estimates based on historical company-specific data, adjusted for expected changes, to estimate forfeitures.
Question 7: A stock plan administrator discovers that a terminated employee exercised options during a blackout period. Which risk category does this scenario PRIMARILY represent?
- Market risk
- Operational risk (Correct answer)
- Credit risk
- Liquidity risk
Correct answer: Operational risk
Exercising during a blackout period due to a process or control failure is an operational risk—a breakdown in internal controls and procedures.
CEP Risk Assessment & Underwriting 2
A company is evaluating whether to allow early exercise of employee stock options.
Which risk is MOST directly introduced by permitting early exercise?