Transcript No Slide Title

Options and Corporate Finance
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Option Basics
Combinations of Options
An Option-Pricing Formula
Stocks and Bonds as Options
Chapter 22 – MBA504
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Options Contracts: Preliminaries
• An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset on (or perhaps before) a given date, at prices
agreed upon today.
• Calls versus Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
When exercising a call option, you “call in” the asset.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you “put” the asset to someone.
Chapter 22 – MBA504
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• Exercising the Option
– The act of buying or selling the underlying asset through the option contract.
• Strike Price or Exercise Price
– Refers to the fixed price in the option contract at which the holder can buy or
sell the underlying asset.
• Expiration date
– The maturity date of the option is referred to as the expiration date, or expiry.
• European versus American options
– European options can be exercised only at expiration date.
– American options can be exercised at any time up to expiration date.
Chapter 22 – MBA504
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American Put Option
Mr. Nash holds an American put option on Delta Triangle,
a non-dividend-paying stock. The strike price of the put is
$40, and Delta Triangle’s stock is currently selling for $35
per share. The current market price of the put is $4.50. Is
this option correctly priced? If not, should Mr. Nash buy
or sell the option in order to take advantage of the
mispricing?
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• In-the-Money
– The exercise price of a call option is less than the spot
price of the underlying asset. For a put option, exercise
price is greater than spot price.
• At-the-Money
– The exercise price is equal to the spot price of the
underlying asset.
• Out-of-the-Money
– The exercise price of a put option is more than the spot
price of the underlying asset. For a put option, exercise
price is less than the spot price.
Chapter 22 – MBA504
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Important Resources
• http://www.cboe.com/: Chicago Board
Options Exchanges
• http://www.cbot.com/: Chicago Board of
Trade
• http://www.cme.com: Chicago Mercantile
Exchange
Chapter 22 – MBA504
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Call Option Payoff at Expiration
• At expiration, an American call option is worth
the same as a European option with the same
characteristics.
– If the call is in-the-money, it is worth ST – E.
– If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
where
ST is the value of the stock at expiration (time T)
E is the exercise price.
C is the value of the call option at expiration
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Call Option Payoffs
Option payoffs ($)
60
40
20
20
40
50
60
80
100
120
Stock price ($)
–20
–40
Exercise price = $50
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Call Option Payoffs
Option payoffs ($)
60
40
20
20
40
50
60
80
100
120
Stock price ($)
–20
–40
Exercise price = $50
Chapter 22 – MBA504
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Call Option Profits
Option payoffs ($)
60
Buy a call
40
20
10
20
40
50
60
80
–10
100
120
Stock price ($)
–20
–40
Exercise price = $50;
option premium = $10
Chapter 22 – MBA504
Sell a call
10
Put Option Payoff at Expiration
• At expiration, an American put option is
worth the same as a European option
with the same characteristics.
• If the put is in-the-money, it is worth E –
ST.
• If the put is out-of-the-money, it is
worthless.
P = Max[E – ST, 0]
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Put Option Payoffs
Option payoffs ($)
60
50
40
20
0
Buy a put
0
20
40
50
60
80
100
Stock price ($)
–20
–40
Exercise price = $50
Chapter 22 – MBA504
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Option payoffs ($)
Put Option Payoffs
40
20
0
Sell a put
0
20
40
50
60
80
100
Stock price ($)
–20
–40
Exercise price = $50
–50
Chapter 22 – MBA504
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Put Option Profits
Option payoffs ($)
60
40
20
Sell a put
10
Stock price ($)
–10
20
40
50
60
80
100
Buy a put
–20
–40
Exercise price = $50; option premium = $10
Chapter 22 – MBA504
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Combinations of Options
• Puts and calls can serve as the
building blocks for more complex
option contracts.
• If you understand this, you can
become a financial engineer,
tailoring the risk-return profile to
meet your client’s needs.
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Buy a Call and a Put -- Straddle
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Protective Put Strategy:
Buy a Put and Buy the Underlying Stock
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Covered Call Strategy
-- buy stock and sell call option
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Suppose you just bought 1,000 shares of Intel stocks at
$___/share, and at the same time short 10 contracts (1000
shares) of Intel call option with the exercise price at
$___/share. Using the information from finance.yahoo.com,
find out (1) your profit when the stock price on Jan 2008 is
$19; (2) your profits when the stock prices on Jan 2008 are
$21, $23 and $27, respectively.
Chapter 22 – MBA504
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Options Trading
• CBOE (started in 1973)
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Equity options
Index options
Options on ETF
Interest rate options
• Particularly, in 2006, CBOE developed new product stock volatility index
(VIX). It is considered as a major hedging product for stock market risks.
• CBOT (started in 1848)
– Commodity options: agricultural products (soybean meal and oil, corn,
whatever), metal (gold or silver), interest rate options, etc
• CME (started in 1919)
– Also have option trading, mainly on futures.
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Put-Call Parity
• Identical payoff
– Buy stock + buy put = buy call + buy bond
– See page 624
• Parity in price
– Price of underlying stock + price of put = price of call +
present value of exercise price
• Applications
– Protective put
– Covered call
– Synthetic stock
Chapter 22 – MBA504
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The Black-Scholes Model
The Black-Scholes Model is
C0  S  N(d1 )  Ee rT  N(d 2 )
Where
C0 = the value of a European option at time t = 0
r = the risk-free interest rate.
σ2
ln( S / E )  (r  )T
2
d1 
 T
d 2  d1   T
N(d) = Probability that a
standardized, normally
distributed, random
variable will be less than
or equal to d.
Chapter 22 – MBA504
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Example
• See page 635
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Stocks and Bonds as Options
• Levered Equity is a Call Option.
– The underlying asset comprise the assets of the firm.
– The strike price is the payoff of the bond.
• If at the maturity of their debt, the assets of the firm are
greater in value than the debt, the shareholders have an inthe-money call, they will pay the bondholders and “call in”
the assets of the firm.
• If at the maturity of the debt the shareholders have an outof-the-money call, they will not pay the bondholders (i.e.
the shareholders will declare bankruptcy) and let the call
expire.
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