1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Options and Corporate Securities Chapter Twenty-Five Prepared by Anne Inglis, Ryerson University

2. 25.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Understand the options terminology Be able to determine option payoffs and pricing bounds Understand the five major determinants of option value Understand employee stock options Understand the various managerial options Understand the differences between warrants and traditional call options Understand convertible securities and how to determine their value

3. 25.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Options: The Basics Fundamentals of Option Valuation Valuing a Call Option Employee Stock Options Equity as a Call Option on the Firm’s Assets Warrants Convertible Bonds Reasons For Issuing Warrants and Convertibles Other Options

4. 25.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Terminology 25.1 Call Put Strike or Exercise price Expiration date Option premium Option writer American Option European Option

5. 25.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Stock Option Quotations Look at Figure 25.1 in the book –Price and volume information for calls and puts with the same strike and expiration Things to notice –Prices are higher for options with the same strike price but longer expirations –Call options with strikes less than the current price are worth more than the corresponding puts –Call options with strikes greater than the current price are worth less than the corresponding puts

6. 25.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Payoffs – Calls 25.2 The value of the call at expiration is the intrinsic value –C 1 = Max(0, S 1 - E) –If S 1 <E, then the payoff is 0 –If S 1 >E, then the payoff is S 1 – E Assume that the exercise price is $35

7. 25.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Payoffs - Puts The value of a put at expiration is the intrinsic value –P 1 = Max (0, E – S 1 ) –If S 1 <E, then the payoff is E-S 1 –If S 1 >E, then the payoff is 0 Assume that the exercise price is $35

8. 25.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Work the Web Example Where can we find option prices? On the Internet, of course. One site that provides option prices is Yahoo Finance Click on the web surfer to go to Yahoo Finance –Enter a ticker symbol to get a basic quote –Follow the options link –Check out “symbology” to see how the ticker symbols are formed

9. 25.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Call Option Bounds Upper bound –Call price must be less than or equal to the stock price Lower bound –Call price must be greater than or equal to the stock price minus the exercise price or zero, whichever is greater If either of these bounds are violated, there is an arbitrage opportunity

10. 25.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 25.3 – Value of a call option before expiration

11. 25.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. A Simple Model An option is “in-the-money” if the payoff is greater than zero If a call option is sure to finish in-the-money, the option value would be –C 0 = S 0 – PV(E) If the call is worth something other than this, then there is an arbitrage opportunity

12. 25.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What Determines Option Values? Stock price –As the stock price increases, the call price increases and the put price decreases Exercise price –As the exercise price increases, the call price decreases and the put price increases Time to expiration –Generally, as the time to expiration increases both the call and the put prices increase Risk-free rate –As the risk-free rate increases, the call price increases and the put price decreases

13. 25.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What about Variance? 25.3 When an option may finish out-of-the-money (expire without being exercised), there is another factor that helps determine price The variance in underlying asset returns is a less obvious, but important, determinant of option values The greater the variance, the more the call and the put are worth –If an option finishes out-of-the-money, the most you can lose is your premium, no matter how far out it is –The more an option is in-the-money, the greater the gain –You gain from volatility on the upside, but don’t lose anymore from volatility on the downside

14. 25.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 25.1 – Five factors that determine option values

15. 25.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Employee Stock Options 25.4 Options that are given to employees as part of their benefits package Often used as a bonus or incentive –Designed to align employee interests with stockholder interests and reduce agency problems –Empirical evidence suggests that they don’t work as well as anticipated due to the lack of diversification introduced into the employees’ portfolios –The stock just isn’t worth as much to the employee as it is to an outside investor

16. 25.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 25.4 – Executive stock options in Canada

17. 25.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Equity: A Call Option 25.5 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 comes due, the option will be exercised and the stockholders retain ownership If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders

18. 25.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Warrants 25.6 A call option issued by corporations in conjunction with other securities to reduce the yield Differences between warrants and traditional call options –Warrants are generally very long term –They are written by the company and exercise results in additional shares outstanding –The exercise price is paid to the company and generates cash for the firm –Warrants can be detached from the original securities and sold separately

19. 25.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Convertibles 25.7 Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the security holder The conversion price is the effective price paid for the stock The conversion ratio is the number of shares received when the bond is converted Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater

20. 25.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 25.5 – Minimum value of a convertible bond versus the value of the stock for a given interest rate

21. 25.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 25.6 – Value of a convertible bond versus value of the stock for a given interest rate

22. 25.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Valuing Convertibles Suppose you have a 10% bond that pays semi-annual coupons and will mature in 15 years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond? –Straight bond value = 1081.44 –Conversion ratio = 1000/100 = 10 –Conversion value = 10*110 = 1100 –Minimum price = $1100

23. 25.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Reasons for Issuing Warrants and Convertibles 25.8 They allow companies to issue cheap bonds by attaching sweeteners to the new bond issue. Coupon rates can then be set at below market rate for straight bonds They give companies the chance to issue common stock in the future at a premium over current prices

24. 25.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 25.3 – The case for and against convertibles

25. 25.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Other Options 25.9 Call provision on a bond –Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value –Increases the required yield on the bond – this is effectively how the company pays for the option Put bond –Gives the bondholder the right to require the company to repurchase the bond prior to maturity at a fixed price Overallotment option –Underwriters have the right to purchase additional shares from a firm in an IPO (chapter 15) Insurance and Loan Guarantees –These are essentially put options Managerial options

26. 25.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz What is the difference between a call option and a put option? What is the intrinsic value of call and put options and what do the payoff diagrams look like? What are the five major determinants of option prices and their relationships to option prices? What are some of the major capital budgeting options? How would you value a convertible bond?

27. 25.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 25.10 The most familiar options are puts and calls. The holder has the right, but not the obligation, to sell (buy) the underlying asset at a given price on or before a given date There are five factors that impact an options value: price of underlying, exercise price, expiration date, risk-free interest rate, and volatility Warrants given the holder the right to buy shares directly from the company at a fixed price for a specified period of time Convertible bonds are a combination of a straight bond and a call option, both of which will affect the minimum value of the bond