Transcript Investments: Analysis and Management, Second Canadian Edition

INVESTMENTS:
Analysis and Management
Second Canadian Edition
W. Sean Cleary
Charles P. Jones
Chapter 19
Options
Learning Objectives
• Define options and discuss why they are used.
• Describe how options work and give some basic
strategies.
• Explain the valuation of options.
• Identify types of options other than puts and
calls.
Rights
• An option to purchase shares directly from the
company at a specified price, usually below
current market price
• Issued to current shareholders
• Trade on an exchange
• Have a very short life (1 to 3 months)
Warrants
• Warrants are a negotiable security


Often issued as part of a “unit”
Trade on an exchange
• Holder has option to



Purchase a specific number of shares
At a specified price
For a specified period of time
• Warrants are issued as a “sweetener to new
issue units, to compensate underwriters and to
increase company’s equity base
Warrant Terminology
• Exercising a warrant

Exchange warrant for shares
 Some extra cash may be needed
• Exercise Price

The price for each share of the underlying security
• Exercise Ratio

The number of shares for each warrant
• Expiry Date

Last day for exercise
Comparison of Warrants with Rights
• Warrants



Life is 6 months to 10 years
Issued as part of new issue units
Exercise price above current market price
• Rights



Life is 1 to 3 months
Issued to existing shareholders
Exercise price below current market price
Options
• Call (Put): Buyer has the right, but not the
obligation, to purchase (sell) a fixed quantity
from (to) the seller at a fixed price before a
certain date


Exercise (strike) price: “fixed price”
Expiration (maturity) date: “certain date”
• Option premium or price: paid by buyer to the
seller to get the “right”
Why Options Markets?
• Financial derivative securities: derive all or part
of their value from another (underlying) security
• Options are created by investors, sold to other
investors
• Why trade these indirect claims?

Expand investment opportunities, lower cost,
increase leverage
Option Terminology
• Exercise (Strike) price: the per-share price at
which the common stock may be purchased or
sold
• Expiration date: last date at which an option can
be exercised
• Option premium: the price paid by the option
buyer to the writer of the option, whether put or
call
How Options Work
• Call buyer (seller) expects the price of the
underlying security to increase (decrease or
stay steady)
• Put buyer (seller) expects the price of the
underlying security to decrease (increase or
stay steady)
• Possible courses of action

Options may expire worthless, be exercised,
or be sold prior to expiry
Options Trading
• Options exchanges


Chicago Board Options Exchange (CBOE)
Montreal Exchange (ME)
• Standardized exercise dates, exercise prices,
and quantities

Facilitate offsetting positions through a
clearing corporation
•
Clearing corporation is guarantor,
handles deliveries
Options Characteristics
• In-the-money options have a positive cash
flow if exercised immediately


Call options: S > E
Put options: S < E
• Out-of-the-money options should not be
exercised immediately


Call options: S < E
Put options: S > E
• If S = E, an option is at the money
Options Characteristics
• Intrinsic value is the value realized from
immediate exercise


Call options: maximum (S0-E, 0)
Put options: maximum (E-S0, 0)
• Prior to option maturity, option premiums exceed
intrinsic value
Time Value = Option Price - Intrinsic Value
Payoff Diagram for a Call Option
Profit per
Option ($)
Buyer
4
0
25
27
29
Stock Price
at Expiration
-4
Seller
How does buying a stock compare
with buying a call option?
Payoff Diagram for a Put Option
Profit per
Option ($)
4
Buyer
0
23
-4
25
27
Stock Price
at Expiration
Seller
How does selling a stock compare
with buying a put option?
Covered Call Writing
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Written call
Protective Put Buying
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Purchased
put
Portfolio Insurance
• Hedging strategy that provides a minimum
return on the portfolio while keeping upside
potential
• Buy protective put that provides the minimum
return

Put exercise price greater or less than the
current portfolio value?
• Problems in matching risk with contracts
Option Price Boundaries
• At maturity, option prices are equal to their
intrinsic values

Intrinsic value is minimum price prior to maturity
• Maximum option prices prior to maturity


Call options: price of stock, S0
Put options: exercise price, E
Hedge Ratios
• Options can be used to control the riskiness of
common stocks

If stock owned, sell calls or buy puts
• Call or put option prices do not usually change
the same dollar amount as the stock being
hedged


Shares purchased per call written = N(d1)
Shares purchased per put purchased = N(d1) - 1
Other Types of Options
• Stock-Index Options: option contracts on a stock
market index
• Interest Rate Options: option contracts on fixed
income securities
• Currency Options: Option contracts whose value
is based on the value of an underlying currency
Basics of Stock-Index Options
• Options available on S&P/TSE 60 Index, S&P
500 Index, NYSE Index, etc.
• Bullish on capital markets implies buying calls
or writing puts
• Bearish on capital markets implies buying
puts or writing calls
• At maturity or upon exercise, cash settlement
of position
Strategies with Stock-Index
Options
• Speculation opportunities similar to options on
individual stocks
• Hedging opportunities permit the management
of market risk


Well-diversified portfolio of stocks hedged by
writing calls or buying puts on stock index
What return can investor expect?
Copyright
Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (The Canadian Copyright
Licensing Agency) is unlawful. Requests for further information
should be addressed to the Permissions Department, John Wiley
& Sons Canada, Ltd. The purchaser may make back-up copies
for his or her own use only and not for distribution or resale. The
author and the publisher assume no responsibility for errors,
omissions, or damages caused by the use of these programs or
from the use of the information contained herein.