Chapter 20 Understanding Options Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Chapter 20 Understanding Options Slides by Matthew Will McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Calls, Puts and Shares Financial Alchemy with Options What Determines Option Value Option Valuation

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

Option Value The value of an option at expiration is a function of the stock price and the exercise price. 6

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 $55 7

Option Value Call option value (graphic) given a $55 exercise price. $20 55 75 Share Price 8

Option Value Put option value (graphic) given a $55 exercise price. 50 55 Share Price 9

Option Value Call option payoff (to seller) given a $55 exercise price. Call option $ payoff 55 Share Price 10

Option Value Put option payoff (to seller) given a $55 exercise price. Share Price 11

Option Value Protective Put - Long stock and long put Long Stock Position Value Share Price 12

Option Value Protective Put - Long stock and long put Position Value Share Price 13

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

Option Value Protective Put - Long stock and long put Protective Put Position Value Share Price 15

Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Long call Position Value Share Price 16

Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Long put Position Value Share Price 17

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

Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Position Value Share Price 19

Option Value Stock Price Upper Limit 20

(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

Time Decay Chart Option Price Stock Price