1. Chapter Twenty-one Options, Corporate Securities and Futures
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

2. Chapter Organisation 21.1 Options: The Basics
21.2 Fundamentals of Options Valuation
21.3 Valuing a Call Option
21.4 Black–Scholes Option Pricing Model
21.5 Equity as a Call Option on the Firm’s Assets
21.6 Types of Equity Option Contracts
21.7 Futures Contracts
21.8 Term Structure of Interest Rates
21.9 Summary and Conclusions
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

3. Chapter Objectives
Understand the key terminology associated with options.
Outline the five factors that determine option values.
Price call options using the Black–Scholes option pricing model.
Discuss the types of equity option contracts offered.
Outline the types of warrants available to investors.
Discuss the characteristics of future contracts.
Understand the term structure of interest rates.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

4. Option Terminology Call option Put option European option
Right to buy a specified asset at a specified price on or before a specified date.
Put option
Right to sell a specified asset at a specified price on or before a specified date.
European option
An option that can only be exercised on a particular date (on expiry).
American option
An option that can be exercised at any time up to its expiry date.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

5. Option Terminology Striking price Expiration date Option premium
The contracted price at which the underlying asset can be bought (call) or sold (put).
Expiration date
The date at which an option expires.
Option premium
The price paid by the buyer for the right to buy or sell an asset.
Exercising the option
The act of buying or selling the underlying asset via the option contract.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

6. Option Contract Characteristics
Expiration month
Option type
Contract size
Expiry
Exercise price
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

7. Option Valuation S1 = share price at expiration S0 = share price today
C1 = value of call option on expiration
C0 = value of call option today
E = exercise price on the option
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

8. Value of Call Option at Expiration
Call option value
at expiration (C1)
S1  E
S1 > E
Share price
at expiration (S1) 45
Exercise price (E)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

9. Value of Call Option at Expiration
Option is out of the money.
Option is in the money.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

10. Value of a Call Option Before Expiration
Call price
(C0)
Upper bound
C0  S0
Lower bound
C0  S0 – E
C0  0 45
Share price (S0)
Exercise price (E)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

11. Call Option Boundaries
Upper bound—a call option will never be worth more than the share itself:
C0  S0
Lower bound—share price cannot fall below 0 and to prevent arbitrage, the call value must be (S0 – E):
The larger of 0 or (S0 – E)
Intrinsic value—option’s value if it was about to expire = lower bound.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

12. Factors Determining Option Values
The value of a call option depends on four factors:
share price
exercise price
time to expiration
risk-free rate.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

13. Another Factor to Consider?
The above four factors are relevant if the option is to finish in the money.
If the option can finish out of the money, another factor to consider is volatility.
The greater the volatility in the underlying share price, the greater the chance the option has of expiring in the money.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

14. The Factors that Determine Option Value
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

15. Black–Scholes Option Pricing Model
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

16. Black–Scholes Option Pricing Model
Note: The risk-free rate, the standard deviation and the time to maturity must all be quoted using the same time units.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

17. Example—Black–Scholes Option Pricing Model
Rf = 8%
 = 30%
t = 0.5 years
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

18. Example—Black–Scholes Option Pricing Model (continued)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

19. Example—Black–Scholes Option Pricing Model (continued)
From the cumulative normal distribution table:
N(d1) = N(1.34) =
N(d2) = N(1.13) =
Therefore, the value of the call option is:
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

20. Equity: A Call Option
Equity can be viewed as a call option on the company’s assets when the firm is leveraged.
The exercise price is the value of the debt.
If the assets are worth more than the debt when it becomes due, the option will be exercised and the shareholders retain ownership.
If the assets are worth less than the debt, the shareholders will let the option expire and the assets will belong to the bondholders.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

21. Equity Option Contracts
Types of equity option contracts offered in Australia:
Exchange traded put and call options on company shares
Exchange traded long dated contracts issued by a financial institution that can then trade them (warrants)
Over-the-counter options on company shares
Convertible notes issued by companies, comprising both a debt and an equity component.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

22. Warrants
A long-lived option that gives the holder the right to buy shares in a company at a specified price.
Types of warrants available:
equity warrants low exercise price warrants
fractional warrants endowment warrants
basket warrants currency warrants
fully covered warrants
index warrants
instalment warrants
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

23. Company Options
A holder is given the right to purchase shares in a company at a specified price over a given period of time.
Usually offered as a ‘sweetener’ to a debt issue.
These options are often detached and sold separately.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

24. Company Options versus Exchange-traded Options
Company options have longer maturity periods and are often European-type options.
Company options are issued as part of a capital- raising program and are therefore limited in number.
The clearing house has no role in the trading of company options.
Company options are issued by firms.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

25. Earnings Dilution
Put and call options have no effect on the value of the firm.
Company options do affect the value of the firm.
Company options cause the number of shares on issue to increase when:
the options are exercised
the debts are converted.
This increase does not lower the price per share but EPS will fall.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

26. Forward Contracts
A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date.
Forward contracts are legally binding on both parties.
They can be tailored to meet the needs of both parties and can be quite large in size.
Positions
Long—agrees to buy the asset at the future date
Short—agrees to sell the asset at the future date
Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

27. Forward Contracts A. Buyer’s perspective B. Seller’s perspective ∆V ∆V
Payoff
profile
∆Poil
∆Poil
Payoff
profile
A. Buyer’s perspective
B. Seller’s perspective
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

28. Futures Contracts
An agreement between two parties to exchange a specified asset at a specified price at a specified time in the future.
Do not need to own an asset to sell a future contract.
Either buy before delivery or close out position with an opposite market position.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

29. Futures Markets
Enable buyers and sellers to avoid risk in commodities (and other) markets with high price variability → hedging.
Involves standardised contracts.
Deposit required by all traders to guarantee performance.
Adverse price movements must be covered daily by further deposits called margins (‘marked to market’).
Futures also available for short-term interest rates, to protect against interest rate movements.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

30. Futures Quotes Commodity, exchange, size, quote units
The contract size is important when determining the daily gains and losses for marking-to-market.
Delivery month
Open price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest
The change in settlement price multiplied by the contract size determines the gain or loss for the day:
Long—an increase in the settlement price leads to a gain
Short—an increase in the settlement price leads to a loss
Open interest is how many contracts are currently outstanding.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

31. Term Structure of Interest Rates
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

32. Term Structure of Interest Rates
Yield curve shows the different interest rates available for investments of different maturities, at a point in time.
The relationship between interest rates of different maturities is called the term structure.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright

33. Factors Determining the Term Structure
Risk preferences—borrowers prefer long-term credit whereas lenders prefer short-term loans (explains upward-sloping yield curve only).
Supplydemand conditions—segmented capital markets can cause supplydemand imbalances (explains all yield curve shapes).
Expectations about future interest rates (most favoured explanation)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright