1. 7-0 Finance 457 7 Chapter Seven The Mechanics of Options Markets

2. 7-1 Finance 457 Mechanics of Options Markets 7.1 Underlying Assets 7.2 Specifications of stock options 7.3 Newspaper Quotes 7.4 Trading 7.5 Commissions 7.6 Margins 7.7 The Options Clearing Corporation 7.8 Regulation 7.9 Taxation 7.10 Warrants, ESOs and Convertibles 7.11 Over-the-counter markets Summary and Conclusions

3. 7-2 Finance 457 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.

4. 7-3 Finance 457 Options Contracts: Preliminaries 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. Expiry –The maturity date of the option is referred to as the expiration date, or the expiry. European versus American options –European options can be exercised only at expiry. –American options can be exercised at any time up to expiry.

5. 7-4 Finance 457 Options Contracts: Preliminaries In-the-Money –The exercise price is less than the spot price of the underlying asset. At-the-Money –The exercise price is equal to the spot price of the underlying asset. Out-of-the-Money –The exercise price is more than the spot price of the underlying asset.

6. 7-5 Finance 457 Options Contracts: Preliminaries Intrinsic Value –The difference between the exercise price of the option and the spot price of the underlying asset. Speculative Value –The difference between the option premium and the intrinsic value of the option. Option Premium = Intrinsic Value Speculative Value +

7. 7-6 Finance 457 7.1 Underlying Assets Stocks –CBOE, PHLX, AMEX, and the Pacific Exchange –Trade on more than 500 different stocks, on round lots Stock indices –Settlement is always in cash. Foreign Currencies –PHLX –European and American options on a variety of currencies Futures Contracts –The futures contract normally matures just after the expiry of the option

8. 7-7 Finance 457 7.2 Specifications of stock options Expiry –10:59 CST on the Saturday immediately following the third Friday of the month. –The last trading day is the third Friday. –Holder of the option has until 4:30 of that Friday to exercise. –His broker has until 10:59 the next day to notify the exchange Expiry Cycles: January –January, April, July, October February –February, May, August, November March –March, June, September, December When one option expires, trading in another begins.

9. 7-8 Finance 457 Strike Price –When a new expiration date is introduced, the two or three strike prices closest to the current stock price are usually selected by the exchange. –If the stock prices move outside this range, new options will be introduced. Terminology: An option class refers to all puts on firm XYZ or all calls on ABC. An option series consists of all the options of a given class with the same expiry and strike (e.g. the IBM October 50 calls) 7.2 Specifications of stock options

10. 7-9 Finance 457 Dividends and Splits –Exchange traded options are adjusted for stock splits and stock dividends. –Exchange traded options are generally not adjusted for cash dividends Position Limits –A position limit is the maximum number of option contracts that an investor can hold on one side of the market. –Short calls and long puts are on the same side. Exercise Limits –Equals the position limit. Controversial issue. 7.2 Specifications of stock options

11. 7-10 Finance 457 Reading The Wall Street Journal

12. 7-11 Finance 457 Reading The Wall Street Journal This option has a strike price of $135; a recent price for the stock is $138.25 July is the expiration month

13. 7-12 Finance 457 Reading The Wall Street Journal This makes a call option with this exercise price in-the- money by $3.25 = $138¼ – $135. Puts with this exercise price are out-of-the-money.

14. 7-13 Finance 457 Reading The Wall Street Journal On this day, 2,365 call options with this exercise price were traded.

15. 7-14 Finance 457 Reading The Wall Street Journal The CALL option with a strike price of $135 is trading for $4.75. Since the option is on 100 shares of stock, buying this option would cost $475 plus commissions.

16. 7-15 Finance 457 Reading The Wall Street Journal On this day, 2,431 put options with this exercise price were traded.

17. 7-16 Finance 457 Reading The Wall Street Journal The PUT option with a strike price of $135 is trading for $.8125. Since the option is on 100 shares of stock, buying this option would cost $81.25 plus commissions.

18. 7-17 Finance 457 7.4 Trading Market Makers –Offer bid and ask quotes on the option. –Market makers ensure that buy and sell orders can always be executed at some price without delay. –The bid-ask spread is their compensation for this liquidity intermediation Offsetting Orders –An investor can close out a long position by issuing an offsetting order to sell the same option. –An investor can close out a short position by issuing an offsetting order to buy the same option.

19. 7-18 Finance 457 7.5 Commissions Commissions vary substantially from one broker to another. A hidden cost is the bid-ask spread

20. 7-19 Finance 457 7.6 Margins Since options already have plenty of leverage, option premia must be paid in full.

21. 7-20 Finance 457 7.6 Margins Naked –If you write a call on shares you don’t own. –The initial margin is the greater of: 100% of the proceeds plus 20% of the underlying share price less the amount if any by which the option is out of the money 100% of the option proceeds plus 10% of the underlying share price Covered Call –IF the option is out of the money, no margin is required

22. 7-21 Finance 457 7.7 The Options Clearing Corporation Has the same function as the clearinghouse in the futures markets. Guarantees option writers fulfill their obligations and keeps a record of all long and short positions. Exercising an option –The OCC randomly selects a member with an outstanding short position in the option. –The member then selects a particular investor who has written the option. –At expiry, all in-the-money options should be exercised unless transactions costs are too high.

23. 7-22 Finance 457 7.8 Regulation Both the exchange and the OCC have rules governing the behavior of traders. Both federal and state regulatory authorities exist. SEC CFTC There haven’t been any huge scandals, so we leave them alone. So far

24. 7-23 Finance 457 7.9 Taxation Determining the tax implications of options strategies can be tricky.

25. 7-24 Finance 457 7.10 Warrants, Executive Stock Options and Convertibles The important questions are: –How can warrants and convertibles be valued? –What impact do warrants and convertibles have on firm value? –What are the differences between warrants, convertibles and call options? –Under what circumstances are warrants and convertibles converted into common stock?

26. 7-25 Finance 457 Warrants Warrants are call options that give the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time. Warrants tend to have longer maturity periods than exchange traded options. Warrants are generally issued with privately placed bonds as an “equity kicker”. Warrants are also combined with new issues of common stock and preferred stock, given to investment bankers as compensation for underwriting services. –In this case, they are often referred to as a Green Shoe Option.

27. 7-26 Finance 457 The Difference Between Warrants and Call Options When a warrant is exercised, a firm must issue new shares of stock. This can have the effect of diluting the claims of existing shareholders.

28. 7-27 Finance 457 Dilution Example Imagine that Mr. Armstrong and Mr. LeMond are shareholders in a firm whose only asset is 10 ounces of gold. When they incorporated, each man contributed 5 ounces of gold, then valued at $300 per ounce. They printed up two stock certificates, and named the firm LegStrong, Inc.. Suppose that Mr. Armstrong decides to sell Mr. Mercx a call option issued on Mr. Armstrong’s share. The call gives Mr. Mercx the option to buy Mr. Armstong’s share for $1,500. If this call finishes in-the-money, Mr. Mercx will exercise, Mr. Armstrong will tender his share. Nothing will change for the firm except the names of the shareholders.

29. 7-28 Finance 457 Dilution Example Suppose that Mr. Armstrong and Mr. LeMond meet as the board of directors of LegStrong. The board decides to sell Mr. Mercx a warrant. The warrant gives Mr. Mercx the option to buy one share for $1,500. Suppose the warrant finishes in-the-money, (gold increased to $350 per ounce). Mr. Mercx will exercise. The firm will print up one new share.

30. 7-29 Finance 457 Dilution Example The balance sheet of LegStrong Inc. would change in the following way: Balance Sheet Before (Book Value) 0 $3,000 Total $3,000Total Assets $3,000 Debt Equity (2 shares) Gold: Liabilities and Equity Assets

31. 7-30 Finance 457 Dilution The balance sheet of LegStrong Inc. would change in the following way: Balance Sheet Before (Market Value) 0 $3,500 Total $3,500Total Assets $3,500 Debt Equity (2 shares) Gold: Liabilities and Equity Assets

32. 7-31 Finance 457 Dilution The balance sheet of LegStrong Inc. would change in the following way: Balance Sheet After (Market Value) 0 $5,000 $3,500 $1,500 Total $5,000Total Assets $5,000 Debt Equity (3 shares) Gold: Cash: Liabilities and Equity Assets Note that Mr. Armstrong’s claim falls in value from $1,750 = $3,500 ÷ 2 to $1,666.67 = $5,000 ÷ 3

33. 7-32 Finance 457 Convertible Bonds A convertible bond is similar to a bond with warrants. The most important difference is that a bond with warrants can be separated into different securities and a convertible bond cannot. Recall that the minimum (floor) value of convertible: –Straight or “intrinsic” bond value –Conversion value The conversion option has value.

34. 7-33 Finance 457 The Value of Convertible Bonds The value of a convertible bond has three components: 1.Straight bond value 2.Conversion value 3.Option value

35. 7-34 Finance 457 Convertible Bond Problem Litespeed, Inc., just issued a zero coupon convertible bond due in 10 years. The conversion ratio is 25 shares. The appropriate interest rate is 10%. The current stock price is $12 per share. Each convertible is trading at $400 in the market. –What is the straight bond value? –What is the conversion value? –What is the option value of the bond?

36. 7-35 Finance 457 Convertible Bond Problem (continued) –What is the straight bond value? –What is the conversion value? 25 shares × $12/share = $300 –What is the option value of the bond? $400 – 385.54 = $14.46

37. 7-36 Finance 457 The Value of Convertible Bonds Convertible Bond Value Stock Price Straight bond value Conversion Value = conversion ratio floor value Convertible bond values Option value

38. 7-37 Finance 457 Reasons for Issuing Warrants and Convertibles A reasonable place to start is to compare a hybrid like convertible debt to both straight debt and straight equity. Convertible debt carries a lower coupon rate than does otherwise-identical straight debt. Since convertible debt is originally issued with an out-of- the-money call option, one can argue that convertible debt allows the firm to sell equity at a higher price than is available at the time of issuance. However, the same argument can be used to say that it forces the firm to sell equity at a lower price than is available at the time of exercise.

39. 7-38 Finance 457 Convertible Debt vs. Straight Debt Convertible debt carries a lower coupon rate than does otherwise- identical straight debt. If the company subsequently does poorly, it will turn out that the conversion option finishes out-of-the-money. But if the stock price does well, the firm would have been better off issuing straight debt. In an efficient financial market, convertible bonds will be neither cheaper or more expensive than other financial instruments. At the time of issuance, investors pay the firm for the fair value of the conversion option.

40. 7-39 Finance 457 Convertible Debt vs. Straight Equity If the company subsequently does poorly, it will turn out that the conversion option finishes out-of-the-money, but the firm would have been even better off selling equity when the price was high. But if the stock price does well, the firm is better off issuing convertible debt rather than equity In an efficient financial market, convertible bonds will be neither cheaper or more expensive than other financial instruments. At the time of issuance, investors pay the firm for the fair value of the conversion option

41. 7-40 Finance 457 Why Warrants and Convertibles are Issued Convertible bonds reduce agency costs, by aligning the incentives of stockholders and bondholders. Convertible bonds also allow young firms to delay expensive interest costs until they can afford them. Support for these assertions is found in the fact that firms that issue convertible bonds are different from other firms: –The bond ratings of firms using convertibles are lower. –Convertibles tend to be used by smaller firms with high growth rates and more financial leverage. –Convertibles are usually subordinated and unsecured.

42. 7-41 Finance 457 Conversion Policy Most convertible bonds are also callable. When the bond is called, bondholders have about 30 days to choose between: 1.Converting the bond to common stock at the conversion ratios. 2.Surrendering the bond and receiving the call price in cash. From the shareholder’s perspective, the optimal call policy is to call the bond when its value is equal to the call price. –In the real world, most firms wait to call until the bond value is substantially above the call price. Perhaps the firm is afraid of the risk of a sharp drop in stock prices during the 30-day window.

43. 7-42 Finance 457 Executive Stock Options Executive Stock Options exist to align the interests of shareholders and managers. Executive Stock Options are call options (technically warrants) on the employer’s shares. –Inalienable –Typical maturity is 10 years. –Typical vesting period is 3 years. –Most include implicit reset provision to preserve incentive compatibility. Executive Stock Options give executives an important tax break: grants of at-the-money options are not considered taxable income. (Taxes are due if the option is exercised.)

44. 7-43 Finance 457 Valuing Executive Compensation FASB allows firms to record zero expense for grants of at- the-money executive stock options. However the economic value of a long-lived call option is enormous, especially given the propensity of firms to reset the exercise price after drops in the price of the stock. Due to the inalienability, the options are worth less to the executive than they cost the company. –The executive can only exercise, not sell his options. Thus he can never capture the speculative value—only the intrinsic value. This “dead weight loss” is overcome by the incentive compatibility for the grantor.

45. 7-44 Finance 457 Top Stock Option Grants CompanyCEOStock Option Award Citigroup, Inc.Sanford Weill$351,319,000 American ExpressHarvey Golub$134,102,000 Cisco Systems, Inc.John Chambers$132,100,000 Bank of AmericaHugh McColl Jr.$104,300,000 Honeywell Inc.Michael Bosignore$121,496,000 ALCOAPaul O’Neill$96,353,000

46. 7-45 Finance 457 7.11 Over-the-counter markets

47. 7-46 Finance 457 Summary and Conclusions