Chapter 25 Options and Corporate Securities Homework: 2, 3,12, & 13

Lecture Organization Options: The Basics Fundamentals of Option Valuation Other Options Hedging with Option Contracts

Option Terminology Call option The right to buy an asset at a fixed price during a particular period of time. Put option The right to sell an asset at a fixed price during a particular period of time. The opposite of a call. Striking price The fixed price in the option contract at which the holder can buy or sell the underlying asset. (Also the exercise price or the strike price.)

Option Terminology Expiration date The last day on which an option may be exercised. Exercising the option The act of buying or selling the underlying asset via the option contract. American option An option that may be exercised at any time until its expiration date. European option An option that may only be exercised on the expiration date.

Call Options Let's say you look in the WSJ on 9/28/2001 and see IBM trading for $69 per share. You think that IBM is going to go up in price. How do you make money? a) b)

Example: Assume that you own the right to buy IBM for $70/share in January. Fill in the following table:

Put options You think that IBM is going to go down in price in January. How do you make money? Let's say you owned the right to sell one share of IBM stock in January for $70/share. January rolls around and the price of IBM has fallen to $60/share. How can you profit from your option?

Example: Assume that you own the right to sell IBM for $70/share in January. Fill in the following table:

Short Calls Example: Say you sell 100 November IBM calls with a strike price of $75. The price of each option is $0.87. Hence you would collect $87 today. When you sell a call option to someone, you are selling them the right to buy 100 shares of IBM stock from you for $75/share in November.

Short Puts Example: Say you sell 100 November IBM puts with a strike price of $75. The price of each option is $7.00. Hence you would collect $ today. When you sell a put option to someone, you are selling them the right to sell 100 shares of IBM stock to you for $75/share in November.

A Sample Globe and Mail, Report on Business Option Quote (Figure 25.1) Source: The Globe and Mail, Report on Business, July 6, 2000, p. B27. Used with permission StockCloseTotal VolOp Int Series BidAskLastVolOp Int Air Canada$ Jul-00$ $19.00p $ $

Value of a Call Option at Expiration (Figure 25.2) Stock price at expiration (S 1 ) Call option value at expiration (C 1 ) S 1  E S 1 > E Exercise price (E) 45 ° As shown, the value of a call at expiration is equal to zero if the stock price is less than or equal to the exercise price. The value of the call is equal to the stock price minus the exercise price (S 1 - E) if the stock price exceeds the exercise price.

Value of a Call Option Before Expiration (Figure 25.3) Stock price (S 0 ) Call price (C 0 ) Exercise price (E) 45 ° Lower bound C 0  S 0 - E C 0  0 Upper bound C 0  S 0 As shown, the upper bound on a call’s value is given by the value of the stock (C 0  S 0 ). The lower bound is either S 0 - E or zero, whichever is larger.

Five Factors That Determine Option Values Current value of the underlying asset Exercise price on the option Time to expiration on the option Risk-free rate Variance of return on underlying asset Factor CallsPuts

Warrants and Convertible Bonds Warrant A call option issued by firms that provides the buyer the right to purchase shares of stocks at a specified price over a given period of time. Convertible bonds Can be exchanged into a fixed number of stocks anytime up to and including the maturity date of the bond. Cannot be separated from the bond.

Other Options Call provision on a bond A call provision provides the issuer the right, but not the obligation to repurchase the bond at a specified price. Put bonds The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed price for a fixed period of time. Green Shoe provision The right of the underwriter to purchase additional shares from the issuer at the offer price in an IPO. Insurance Insurance obligates the insurer to purchase the underlying asset at a specified price for a specified period (the term of the policy).

Risk Profile for a Wheat Grower

Risk Profile for a Wheat Buyer

Option Payoff Profiles  V V  P P A. Buying a call

Option Payoff Profiles (continued) B. Selling a call  V V  P P

Option Payoff Profiles (continued) C. Buying a put  V V  P P

Option Payoff Profiles (concluded) D. Selling a put  V V  P P

Sample National Post Future Option Price Quotations (Figure 24.16) FUTURE OPTION PRICES Thursday, June 1, 2000 The National Post, June 1, Used with permission.

Example Option &Strike Calls Puts NY ClosePriceExpirationVol.LastVol.Last RWJR 7470Mar2303 1/ /8 7470Apr /8 7470Jul1398 5/ /8 7470Oct 609 7/ /8 Consider the following options quote.

Solution to Example a. Are the call options in the money? What is the intrinsic value of an RWJR Corp. call option? b. Are the put options in the money? What is the intrinsic value of an RWJR Corp. put option? c. Two of the options are clearly mispriced. Which ones? At a minimum, what should the mispriced options sell for? Explain how you could profit from the mispricing in each case.