Corporate Finance, Concise Understanding Options Principles of Corporate Finance, Concise Second Edition Chapter 16 Understanding Options Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 2 1

Topics Covered Calls, Puts and Shares Financial Alchemy with Options What Determines Option Values? 2 2 2 2 3 2

Option Terminology Call Option Right to buy an asset at a specified exercise price on or before the exercise date. Put Option Right to sell an asset at a specified exercise price on or before the exercise date. 4

Option Obligations 5

Options Terminology Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.) Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time. Call Option - The right to buy a security at a specified price within a specified time. Put Option - The right to sell a security at a specified price within a specified time. Option Premium - The price paid for the option, above the price of the underlying security. Intrinsic Value - Diff between the strike price and the stock price Time Premium - Value of option above the intrinsic value 2

Options Terminology Exercise Price - (Striking Price) The price at which you buy or sell the security. Expiration Date - The last date on which the option can be exercised. American Option - Can be exercised at any time prior to and including the expiration date. European Option - Can be exercised only on the expiration date. All options “usually” act like European options because you make more money if you sell the option before expiration (vs. exercising it). 3 vs. 70-68=2 3

Selected prices for puts and calls September 2008 Google Stock Selected prices for puts and calls September 2008

Option Value The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given a exercise price of $80 7

Option Value Google Call option value (graphic) given a $430 exercise price. $430 Call option value 430 Share Price 8

Option Value Google Put option value (graphic) given a $430 exercise price. $430 Put option value 430 Share Price 9

Option Value Google Call option payoff (to seller) given a $430 exercise price. Call option $ payoff $430 430 Share Price 10

Option Value Google Put option payoff (to seller) given a $430 exercise price. Put option $ payoff $430 430 Share Price 11

Option Value Call buyer profit – assume strike of $430 and option price of $54.35 Long call Break even Position Value -54.35 430 484.35 Share Price 18

Option Value Put seller profit – assume strike of $430 and option price of $48.55 Break even Short put Position Value +48.55 381.45 430 Share Price 18

Option Value Masochists’ Strategy?- Long stock and short call “Silly Strategy” Short Call Position Value Share Price 14

Option Value Protective Put - Long stock and long put Long Stock Position Value Long Put Share Price 14

Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Long call Long put Straddle Position Value Share Price 18

Financial Alchemy

Financial Alchemy

Financial Alchemy

Financial Alchemy

Financial Alchemy

Option Value Components of the Option Price 1 - Underlying stock price = Ps 2 - Striking or Exercise price = S 3 - Volatility of the stock returns (standard deviation of annual returns) = v 4 - Time to option expiration = t = days/365 5 - Time value of money (discount rate) = r 6 - PV of Dividends = D = (div)e-rt

Time Decay Chart Option prices decline, ceribus paribus, when the time to expiration declines. Option Price 30 days to expiration 90 days to expiration 60 days to expiration Stock Price

(Stock price - exercise price) or 0 Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 which ever is higher 21

Option Value The value of an option is bound, on the high end, by the value of the underlying stock. The lower bound is the value of exercising the option. In between, the major determinants are exercise price and stock price.

Option Value The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceribus paribus.

Option Value Similar to time decay, the value of an option will be higher when more volatility exists.

Option Value

Option Value

Web Resources Click to access web sites Internet connection required www.cboe.com http://finance.yahoo.com www.optionscentral.com www.pmpublishing.com