T22.1 Chapter Outline Chapter 22 Options and Corporate Securities Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.2 Option Terminology American option Call option European option Exercising the option Expiration date Striking price Put option

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.3 A Sample Wall Street Journal Option Quotation (Table 22.1) LISTED OPTIONS QUOTATIONS -Call- -Put- Option/StrikeExp.Vol.LastVol.Last IBM 140Feb 128 3/ / Feb / / Feb / / Feb / Feb / / Feb / Apr / Monday, January 20, 1997 Reprinted by permission of The Wall Street Journal,  1997 Dow Jones and Company, Inc., Monday, January 20, All Rights Reserved Worldwide.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.4 Value of a Call Option at Expiration (Figure 22.1) Stock price at expiration (S 1 ) Call option value at expiration (C 1 ) S 1  E S 1 > E Exercise price (E) 45 °

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.5 Value of a Call Option Before Expiration (Figure 22.2) 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc Option Payoffs What are the payoffs to buying 50 February 170 call contracts? Each contract involves 100 shares, and hence options. The closing price is $5 per option The cost of the position is $5*100*50 = $25,000 What are the payoffs?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc Option Payoffs

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.6 Five Factors That Determine Option Values (Table 22.2) Factor CallsPuts Current value of the underlying asset(+) (  ) Exercise price on the option (  ) (+) Time to expiration on the option(+) (+) Risk-free rate (+) (  ) Variance of return on the underlying asset (+) (+)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.7 Terminology: Convertible Bonds Conversion premium Conversion price Conversion ratio Conversion value Convertibility Floor value for a convertible Straight bond value

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.8 Minimum Value of a Convertible Bond (Figure 22.3) Stock price Minimum convertible bond value (floor value) Straight bond value greater than conversion value Conversion value Straight bond value less than conversion value Straight bond value Convertible bond floor value Conversion ratio

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.9 Value of a Convertible Bond (Figure 22.4) Stock price Convertible bond value Straight bond value greater than conversion value Conversion value Straight bond value less than conversion value Straight bond value Convertible bond values Conversion ratio Floor value

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.10 The Case For and Against Convertibles (Table 22.4) If Firm Does Poorly If Firm Prospers Low stock price and no High stock price and conversion conversion Convertible bonds issued instead of straight bonds Convertible bonds issued instead of common stock Cheap financing because coupon rate is lower (good outcome) Expensive financing because firm could have issued common stock at high prices (bad outcome) Expensive financing because bonds are converted, which dilutes existing equity (bad outcome) Cheap financing because firm issues stock at high prices when bonds are converted (good outcome)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.11 Other Options Call provision on a bond Put bonds Green Shoe provision Insurance Loan guarantees

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.12 Chapter 22 Quick Quiz 1. What is the difference between a call option and a put option? 2. All else equal, which is more valuable to the holder, an American option or a European option? Why? 3. What is the “upper bound” value of a call option? 4. What is the relationship between the risk-free rate and the value of a call option? Explain. 5. What is the “floor value” of a convertible bond?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.13 Solution to Problem 22.2 Option &Strike Calls Puts NY ClosePriceExpirationVol.LastVol.Last Sleight 7470Mar2303 1/ /8 7470Apr /8 7470Jul1398 5/ /8 7470Mar2303 1/ /8 Consider the following options quote.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.13 Solution to Problem 22.2 (concluded) a. Are the call options in the money? What is the intrinsic value of a Sleight Corp. call option? The strike price is 70 and the value of the underlying stock is 74. The call options, therefore, (are/are not) in the money. b. Are the put options in the money? What is the intrinsic value of a Sleight Corp. put option? The strike price is 70 and the value of the underlying stock is 74. The put options, therefore, (are/are not) in the money. c. Two of the options are mispriced. Which ones? At a minimum, what should the mispriced options sell for? Explain how you could profit from the mispricing in each case.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.14 Solution to Problem 22.4 The price of Gyrostat stock will be either $75 or $95 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 5 percent. a. Suppose the current price of Gyrostat stock is $90. What is the value of the call option if the exercise price is $70? b. Suppose the exercise price is $90 in part (a). What would the value of the call option be?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.14 Solution to Problem 22.4 (conclusion) a. What is the value of the call option if the exercise price is 70? The present value of the exercise price = $70/(1.05) = $66.67 S 0 = PV exercise price + C 0 $90 = $ C 0 C 0 = $23.33 b. Suppose the exercise price is $90 in part (a). What would the value of the call option be? $90 = _____ + _____ C 0 = $4.64

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc T22.15 Solution to Problem 22.6 A one-year call option contract on the common stock of Isomer Partners Co. sells for $1,900. In one year, the stock will be worth $30 or $50 per share. The exercise price on the call option is $35. What is the current value of the stock if the risk-free rate is 8 percent? S 0 = _____ x $19 + _____/(1.08) = $53.11