1. copyright © 2003 McGraw Hill Ryerson Limited 25-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 25-2 Chapter 25 Options Chapter Outline  Calls and Puts  What Determines Option Values  Spotting the Option

3. copyright © 2003 McGraw Hill Ryerson Limited 25-3 Calls and Puts What is an Option?  An option gives the holder (purchaser) of that option the right, but not the obligation, to do something at a future date.  In finance, there are two types of options you will have to deal with: Call Options Put Options

4. copyright © 2003 McGraw Hill Ryerson Limited 25-4 Calls and Puts What is an Option?  Call Options A call option is the right to buy an asset at a specified exercise price on or before the exercise date.  Put Options A put option is the right to sell an asset at a specified exercise price on or before the exercise date.

5. copyright © 2003 McGraw Hill Ryerson Limited 25-5 Calls and Puts Call Options  You buy a call option on ABC shares, which gives you the right to buy an ABC share for $30 (the exercise price) on or before December 31 st of the current year.  If you have the right to buy an ABC share, then someone must have the obligation to sell it to you if you want to buy it. The person who is obligated to sell the asset to you is known as the seller or writer of the call option.

6. copyright © 2003 McGraw Hill Ryerson Limited 25-6 Calls and Puts Put Options  You buy a put option on ABC shares, which gives you the right to sell an ABC share for $30 (the exercise price) on or before December 31 st of the current year.  If you have the right to sell an ABC share, then someone must have the obligation to buy it from you if you want to sell. The person who is obligated to buy the asset from you is known as the seller or writer of the put option.

7. copyright © 2003 McGraw Hill Ryerson Limited 25-7 Calls and Puts BuyerSeller Call OptionRight to buy assetObligation to sell asset Put OptionRight to sell assetObligation to buy asset  The seller of the option must be compensated for taking on the obligation. Thus, the buyer of the option must pay a price for the option. The price of an option is called its premium. Calls and Puts  To summarize:

8. copyright © 2003 McGraw Hill Ryerson Limited 25-8 Calls and Puts Stock Price$20$25$30$35$40$45 Call Value$0 $0 $0 $5$10$15 Put Value$10 $5 $0 $0 $0 $0 Calls and Puts  The value of an option at expiration is a function of the asset’s price and the exercise price.  Assuming the exercise price is $30 and ABC shares have the following values, then at expiry, the following would occur:

9. copyright © 2003 McGraw Hill Ryerson Limited 25-9 Calls and Puts Stock Price Value of Option at Expiration at Expiration Call Option Greater thanStock Price – Exercise Price exercise price Less than exercise price Zero Put Option Greater than Zero exercise price Less than exercise price Exercise Price – Stock Price Summary: Valuing Calls and Puts

10. copyright © 2003 McGraw Hill Ryerson Limited 25-10 Calls and Puts Value Diagrams  Sometimes it is easier to draw a diagram of an option to understand the pay-offs to the buyer and the seller of the option.  In each of the diagrams which follows, the option has an exercise price of $30 and allows the holder to buy or sell one ABC share.  Note: For simplicity, the premium is assumed to be zero in each of the diagrams.

11. copyright © 2003 McGraw Hill Ryerson Limited 25-11 Option Value Call option value to buyer given a $30 exercise price. Share Price Call option value 20 30 40 ?$10

12. copyright © 2003 McGraw Hill Ryerson Limited 25-12 Option Value Put option value to a buyer given a $30 exercise price. ? Share Price Put option value 20 30 40 $30 $10

13. copyright © 2003 McGraw Hill Ryerson Limited 25-13 Option Value Share Price Call option $ payoff 30 40 Call option pay-off to seller (writer) given a $30 exercise price. ? -$10

14. copyright © 2003 McGraw Hill Ryerson Limited 25-14 Option Value Put option pay-off to seller (writer) given a $30 exercise price. Share Price Put option $ payoff 20 30 -$30 ?-$10

15. copyright © 2003 McGraw Hill Ryerson Limited 25-15 Financial Alchemy with Options Protective Put  Now we will look at how options can be used to modify the risk characteristics of a portfolio.  Suppose you are generally optimistic about ABC’s prospects, but that you don’t like high levels of risk.  You buy the stock and you also buy a put option with a $30 exercise price. If the stock price rises, your option will be worthless. If the stock price falls, however, your losses are limited to $30 since the put option gives you the right to sell the stock for $30.

16. copyright © 2003 McGraw Hill Ryerson Limited 25-16 Financial Alchemy with Options Protective Put  Because you hold the stock and the put, your losses are limited to $30.  The value of each component will be as follows: Stock Price < $30 Stock Price  $30 Value of Stock Stock priceStock price + Value of Put $30 - stock price 0 Total Value $30Stock Price

17. copyright © 2003 McGraw Hill Ryerson Limited 25-17 Financial Alchemy with Options Protective Put  This strategy is called a protective put because the put option protects you from losses.  In effect, you have purchased stock price insurance.  Note that such protection is not free: You will have to pay a premium to purchase the put. If the premium for this option is $2.15, then your insurance against the stock falling below $30 a share will have cost you $2.15.

18. copyright © 2003 McGraw Hill Ryerson Limited 25-18 Financial Alchemy with Options Share Price Position Value Protective Put Long the Stock Protective Put – Long Stock and Long Put Long Put

19. copyright © 2003 McGraw Hill Ryerson Limited 25-19 Financial Alchemy with Options Straddle  Suppose you think that ABC will be subject to considerable volatility over the next couple of months. How can you bet on the expected volatility of the stock?  A straddle is a strategy for profiting from high volatility.  A straddle involves purchasing a put and a call. If the stock price falls, the put will be profitable. If the stock price rises, the call will be profitable.

20. copyright © 2003 McGraw Hill Ryerson Limited 25-20 Financial Alchemy with Options Straddle  There is a cost to your strategy: you will have to pay a premium for the call and for the put. Unless the stock price moves far enough that the profit on either the put or call covers the initial cost of the two options, you will lose money.  The net position of the strategy is shown by the dashed V-shaped line on the next slide,  The profit, taking into account the premiums on the this strategy, is shown by the solid V- shaped line on the next slide.

21. copyright © 2003 McGraw Hill Ryerson Limited 25-21 Share Price Position Value Financial Alchemy with Options Straddle Straddle – Long Call and Long Put Long Call Long Put

22. copyright © 2003 McGraw Hill Ryerson Limited 25-22 Financial Alchemy with Options Other Strategies  There are many other option strategies which can be pursued.  Combining options with various assets, gives you considerable leeway to tailor the risk features of a portfolio.  For practice, try Check Point 25.3 on page 745 of your text.

23. copyright © 2003 McGraw Hill Ryerson Limited 25-23 What Determines Option Values? Upper and Lower Limits of Option Value  The upper limit on the value of a call option is the stock price itself. Thus, the option cannot be worth more than the asset it entitles you to buy.  The lower limit on the value of a call option is the value of the call at expiry. After expiry, any option is valueless. At expiry the option has its lowest value. Thus, before expiry, the value of an option cannot be less than its value at expiry.  These limits can be seen on the next slide.

24. copyright © 2003 McGraw Hill Ryerson Limited 25-24 Option Value Upper and Lower Limits on Option Values Share Price Call option value 20 30 40 Value of the Stock Value of Option at Expiry Value of Option before expiry

25. copyright © 2003 McGraw Hill Ryerson Limited 25-25 What Determines Option Values? Upper and Lower Limits of Option Value  Figure 25.7 on page 746 of your text is a copy of the previous slide.  If you look at Figure 25.7, you should notice the following: Point A: When the stock is worthless, the option is worthless. Point B: When the stock price becomes very high, the option price approaches the stock price less the present value of the exercise price. Point C: The option price before expiry exceeds its value at expiry.

26. copyright © 2003 McGraw Hill Ryerson Limited 25-26 What Determines Option Values? Upper and Lower Limits of Option Value  How high point C is on the graph will be determined by a number of factors: How High Interest Rates Are  Having a call option is the same as buying the stock on credit.  You pay the purchase price of the option, but you do not have to pay the exercise price for the stock until you exercise the option.  The higher interest rates are, the more valuable this option to delay will be.

27. copyright © 2003 McGraw Hill Ryerson Limited 25-27 What Determines Option Values? Upper and Lower Limits of Option Value  How high point C is on the graph will be determined by a number of factors: The Length of Time Until Expiry  The longer the life of the asset, the greater the chance that you will find an opportunity to exercise it.  Thus, options with a long life are more valuable than those with a short life.

28. copyright © 2003 McGraw Hill Ryerson Limited 25-28 What Determines Option Values? Upper and Lower Limits of Option Value  How high point C is on the graph will be determined by a number of factors: The Standard Deviation of the Price of the Stock.  Substantial movement in the price of the stock is very valuable in an option.  A stock whose price moves by 1% or 2% is not worth much.  A stock whose price halves or doubles is very valuable.

29. copyright © 2003 McGraw Hill Ryerson Limited 25-29 What Determines Option Values? Upper and Lower Limits of Option Value  To see how this works, imagine that ABC has an equal chance of being worth $25 or $35 at expiry.  The expected value of the option will be: Stock Price at Expiry$25$35Avg Value $ 0$ 5 $2.50  Now imagine that ABC has an equal chance of being worth $20 or $40 at expiry.  The expected value of the option will be: Stock Price at Expiry$20$40Avg Value $ 0$10 $5.00

30. copyright © 2003 McGraw Hill Ryerson Limited 25-30 What Determines Option Values? Upper and Lower Limits of Option Value  These two cases highlight a valuable asymmetry in options: If the stock price is below the exercise price at expiry, the option is valueless.  This is true regardless of whether the stock price is one cent below the exercise price, or many dollars below it. However, if the stock price is above the exercise price, the holder reaps all the benefits of stock price advances.

31. copyright © 2003 McGraw Hill Ryerson Limited 25-31 What Determines Option Values? Upper and Lower Limits of Option Value  Thus, in our example, if the stock price is $35, the option is worth $5.  But if the stock price jumps to $40, the value of the option doubles to $10.  Therefore, volatility helps an option owner.

32. copyright © 2003 McGraw Hill Ryerson Limited 25-32 What Determines Option Values? What Affects the Price of a Call Option? If the following increase: The value of the call will: STOCK PRICE DECREASE INTEREST RATE TIME TO EXPIRY VOLATILITY OF THE STOCK PRICE INCREASE EXERCISE PRICE INCREASE

33. copyright © 2003 McGraw Hill Ryerson Limited 25-33 What Determines Option Values? Valuing Options  Calculating the value of an option is a difficult undertaking.  You can see two methods which are used by reading: The Finance in Action Box on page 750 of your book. Appendix 25A, in which the Black-Scholes Option Pricing Model is described.

34. copyright © 2003 McGraw Hill Ryerson Limited 25-34 Spotting the Option Options on Real Assets  Real options are options embedded in real assets.  You learned in Chapter 8, that capital investment projects are more valuable if they have the flexibility provided by options.  The most common real options are: The option to expand the project at a later date. The option to abandon the project. The option to change how the project will operate and/or what it will produce. The option to delay implementation.

35. copyright © 2003 McGraw Hill Ryerson Limited 25-35 Spotting the Option Options on Financial Assets  When companies issue securities, they often include an option in the package. Warrants  The right to buy shares from a company at a stipulated price before a specified date. Convertible Security  The right to exchange the security for another security, usually common shares. Callable Bond  The right of the issuer to repurchase the bond before maturity.

36. copyright © 2003 McGraw Hill Ryerson Limited 25-36 Summary of Chapter 25  There are two types of options: Call options confer the right to buy an asset for a specific exercise price on or before a specified date. Put options confer the right to sell an asset for a specific exercise price on or before a specified date.  The payoff to buying a call is the maximum of the stock price minus the exercise price or zero.  The payoff to buying a put is the maximum of the exercise price minus the stock price or zero.  The payoff to the seller of an option is the mirror image of the the payoff to the option buyer.

37. copyright © 2003 McGraw Hill Ryerson Limited 25-37 Summary of Chapter 25 If the following increase: The value of a call will: STOCK PRICE DECREASE INTEREST RATE TIME TO EXPIRY VOLATILITY OF THE STOCK PRICE INCREASE EXERCISE PRICE INCREASE

38. copyright © 2003 McGraw Hill Ryerson Limited 25-38 Summary of Chapter 25  Options may be present in capital investment projects.  Such options add value to the project and include the right to expand, abandon or delay implementation of the project.  Options may also be present in security issue.  Such options include warrants, convertible securities and the right of the issuer to call a security.