1. Chapter 23 Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Options

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 2 Topics Covered  Calls and Puts  What Determines Option Values  Spotting the Option

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 3 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.

4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 4 Option Obligations

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 5 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 $180

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 6 Option Value Call option value (graphic) given a $180 exercise price. Share Price Call option value 180 220 $40

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 7 Option Value Put option value (graphic) given a $180 exercise price. Share Price Put option value 140 180 $40

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 8 Option Value Call option payoff (to seller) given a $180 exercise price. Share Price Call option $ payoff 180

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 9 Option Value Put option payoff (to seller) given a $180 exercise price. Share Price Put option $ payoff 180

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 10 Option Value Protective Put - Long stock and long put Share Price Position Value Protective Put Long Put Long Stock

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 11 Option Value Protective Put - Long stock and long put Share Price Position Value Protective Put

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 12 Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Share Price Position Value Straddle Long put Long call

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 13 Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Share Price Position Value Straddle

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 14 Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 which ever is higher

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 15 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)

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 16 Option Value Black-Scholes Option Pricing Model O C = P s [N(d 1 )] - S[N(d 2 )]e -rt

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 17 Options on Real Assets Real Options - Options embedded in real assets

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 18 Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 23- 19 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.