Chapter 24 Fundamentals of Corporate Finance Fourth Edition Options Slides by Matthew Will Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
24- 2 Irwin/McGraw Hill Topics Covered Calls and Puts What Determines Option Values Spotting the Option
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Terminology Put Option Right to sell an asset at a specified exercise price on or before the exercise date. Call Option Right to buy an asset at a specified exercise price on or before the exercise date.
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Obligations
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill 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
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Call option value (graphic) given a $55 exercise price. Share Price Call option value $10
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Put option value (graphic) given a $55 exercise price. Share Price Put option value $10
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Call option payoff (to seller) given a $55 exercise price. Share Price Call option $ payoff 55
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Put option payoff (to seller) given a $55 exercise price. Share Price Put option $ payoff 55
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Components of the Option Price 1 - Underlying stock price 2 - Striking or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate)
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Black-Scholes Option Pricing Model O C = P s [N(d 1 )] - S[N(d 2 )]e -rt
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill WSJ Options (9/29/03) How to Value a Call Option OPTION AMD STRIKEEXPCALL VOL CALL LAST PUT VOL PUT LAST Oct Jan Jan
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option to Expand Technique Start Pilot Project Plan to invest if pilot project is successful Example: Pilot project involves the LEGAL sale and distribution of a new software enabling copying of copyright protected music and video CD’s Initial Investment for Pilot = $200,000 PV of Anticipated Profits over 1 year: = $150,000 What is NPV? But provides an option to expand if successful. In particular
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Project Expansion Initial Investment $8 million PV of Anticipated Cash Flow = 40 times pilot project Cash Flows (PV) + $1 million That is present value is: 40*150, = $7 million Should you undertake the project? Returns on Pilot Project has a standard deviation of $25,000 so standard deviation of the Full blown project is ~~ $200,000 =.20 Should the Project be undertaken?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Financials NPV of full-blown option? But Note that if the project ends up generating cash flow of more than $8 million we get a positive NPV, but if less we get zero. That is, do not invest the $8 million. What is the value of this option?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Exercise price = $8 million Current “Price” = $7 million
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Financial Assets Warrants - Right to buy shares from a company at a stipulated price before a set date. Convertible Bond - Bond that the holder may exchange for a specific number of shares. Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price.
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Calculate the Option value Go to
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