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

2. 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

3. 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

4. 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 $ 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

5. 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

6. Important Resources
Chicago Board Options Exchanges
Chicago Board of Trade
Chicago Mercantile Exchange
Chapter 22 – MBA504

7. 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

8. Call Option Payoffs Exercise price = $50 Buy a call 60 4020 20 40 60 80
100
120 50
Stock price ($)
–20
Exercise price = $50
–40
Chapter 22 – MBA504

9. Call Option Payoffs Exercise price = $50 Sell a call 60 4020 20 40 60 80
100
120 50
Stock price ($)
–20
Exercise price = $50
Sell a call
–40
Chapter 22 – MBA504

10. 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

11. 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

12. Put Option Payoffs Exercise price = $50 Buy a put 60 50 4020
Buy a put 20 40 60 80
100 50
Stock price ($)
–20
Exercise price = $50
–40
Chapter 22 – MBA504

13. Put Option Payoffs Exercise price = $50 Sell a put 4020
Sell a put 20 40 60 80
100 50
Stock price ($)
–20
Exercise price = $50
–40
–50
Chapter 22 – MBA504

14. Put Option Profits Exercise price = $50; option premium = $1060 40
Option payoffs ($) 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

15. 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

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

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

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

19. 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

20. 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

21. 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

22. 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

23. Example
See page 635
Chapter 22 – MBA504

24. 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