Options and Corporate Finance Option Basics Combinations of Options An Option‑Pricing Formula Stocks and Bonds as Options Chapter 22 – MBA504

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

Strike Price or Exercise Price Expiration date 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

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? Chapter 22 – MBA504

In-the-Money At-the-Money Out-of-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

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

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 Chapter 22 – MBA504

Call Option Payoffs Exercise price = $50 Buy a call 60 40 20 20 40 60 80 100 120 50 Stock price ($) –20 Exercise price = $50 –40 Chapter 22 – MBA504

Call Option Payoffs Exercise price = $50 Sell a call 60 40 20 20 40 60 80 100 120 50 Stock price ($) –20 Exercise price = $50 Sell a call –40 Chapter 22 – MBA504

Call Option Profits Exercise price = $50; option premium = $10 –20 120 20 40 60 80 100 –40 Stock price ($) Option payoffs ($) Buy a call 10 50 –10 Exercise price = $50; option premium = $10 Sell a call Chapter 22 – MBA504

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] Chapter 22 – MBA504

Put Option Payoffs Exercise price = $50 Buy a put 60 50 40 20 Buy a put 20 40 60 80 100 50 Stock price ($) –20 Exercise price = $50 –40 Chapter 22 – MBA504

Put Option Payoffs Exercise price = $50 Sell a put 40 20 Sell a put 20 40 60 80 100 50 Stock price ($) –20 Exercise price = $50 –40 –50 Chapter 22 – MBA504

Put Option Profits Exercise price = $50; option premium = $10 60 40 Option payoffs ($) 20 Sell a put 10 Stock price ($) 20 40 50 60 80 100 –10 Buy a put –20 –40 Exercise price = $50; option premium = $10 Chapter 22 – MBA504

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. Chapter 22 – MBA504

Buy a Call and a Put -- Straddle Chapter 22 – MBA504

Protective Put Strategy: Buy a Put and Buy the Underlying Stock Chapter 22 – MBA504

Covered Call Strategy -- buy stock and sell call option Chapter 22 – MBA504

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

Options Trading CBOE (started in 1973) CBOT (started in 1848) 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. Chapter 22 – MBA504

Put-Call Parity Identical payoff Parity in price Applications 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

The Black-Scholes Model The Black-Scholes Model is Where C0 = the value of a European option at time t = 0 r = the risk-free interest rate. N(d) = Probability that a standardized, normally distributed, random variable will be less than or equal to d. Chapter 22 – MBA504

Example See page 635 Chapter 22 – MBA504

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 in-the-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 out-of-the-money call, they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire. Chapter 22 – MBA504