Financial Options and

Applications in Corporate
Finance
Chapter 8
What is a financial option?
An option is a contract which gives its holder
the right, but not the obligation, to buy (or
sell) an asset at some predetermined price
within a specified period of time.
What is the single most important
characteristic of an option?
It does not obligate its owner to take any
action. It merely gives the owner the right to
buy or sell an asset.
Option example
You own 100 shares of GCC, which on Jan 9,
2013, sold for $53.50 per share. You could sell
to someone the right to buy your 100 shares
at any time until May 14, 2013, at a price of
$55 per share.
This is called an American option, because it
can be exercised any time before it expires.
A European option can only be exercised on its
expiration date.
Option Terminology
Call option: An option to buy a specified
number of shares of a security within some
future period.
Put option: An option to sell a specified
number of shares of a security within some
future period.
Option Terminology (Continued)
Exercise (or strike) price: The price stated in
the option contract at which the security can
be bought or sold.
Option price: The market price of the option
contract.
Option Terminology (Continued)
Expiration date: The date the option matures.
Exercise value: The value of a call option if it
were exercised today
= Current stock price - Strike price.
Note: The exercise value is zero if the stock
price is less than the strike price.
Option Terminology (Continued)
Covered option: A call option written against
stock held in an investors portfolio.
Naked (uncovered) option: An option sold
without the stock to back it up.
Option Terminology (Continued)
In-the-money call: A call whose exercise price
is less than the current price of the underlying
stock.
Out-of-the-money call: A call option whose
exercise price exceeds the current stock price.
Option Terminology (Continued)
Conventional options are generally written for
six months or less.
LEAPS: Long-term Equity AnticiPation
Securities that are similar to conventional
options except that they are long-term
options with maturities of up to 2 1/2 years.
Option example
You purchase an option to buy 100 shares of NQP
@ $50 per share.
What type of option is this?
Call option
What is $50/sh?
Strike (or exercise) price
The options were purchased at $2.25/option
What is this called and how much did you pay for
the option contract?
Option Price; $2.25*100 = $225
Option example (cont)
If the price of NDQ shares is $60, your call
option is:
In-the-money
If you were to exercise your option, how much
profit would you make?
Sell at Market Price (60*100) = 6,000
Less: Buy at Strike Price - (50*100) = -5,000
Less: Option Price - (2.5*100) = -225
Profit (before taxes & commissions) =775
In-class
Put option on 100 shares of FTG at strike price
of $57/sh. Option price is 2.32/option.
If the market price of FTG is $43/sh, what is
your profit?

Sell at Strike Price (57*100) = 5,700

Less: Buy at Market Price - (43*100) = -4,300
Less: Option Price - (2.32*100) = -232
Profit (before taxes & commissions) =1,168
Factors That Affect the Value of
a Call Option
Market price versus strike price: The higher the
stocks market price in relation to the strike price,
the higher will be the call option price.
Level of strike price: The higher the strike price,
the lower the call option price.
Length of option: The longer the option period,
the higher the option price.
This occurs because the longer the time before
expiration, the greater the chance that the stock price
will climb substantially above the exercise price. Thus,
option prices increase as the expiration date is
lengthened.
Consider the following data:
Exercise price = $25.
Stock Price Call Option Price
$25 $3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
Exercise Value vs. Stock Price
Price of Strike Exercise Value
stock (a) price (b) of option (a)(b)
$25.00 $25.00 $0.00
30.00 25.00 5.00
35.00 25.00 10.00
40.00 25.00 15.00
45.00 25.00 20.00
50.00 25.00 25.00
Option Value vs. Exercise Value
Exercise Value Mkt Price Time Value
Of option (c) Of option (d) (d) (c)

$0.00 $3.00 $3.00

5.00 7.50 2.50
10.00 12.00 2.00
15.00 16.50 1.50
20.00 21.00 1.00
25.00 25.50 0.50
Problem
The exercise price on one of Flanagan
Companys options is $15, its exercise value is
$22, and its time value is $5. What are the
options market value and the price of the
stock?
Solution
STI stock & option data:
Option Price and Exercise Value
Exercise Value vs. Option Price 1
The market value of the option is zero when
the stock price is zero.
This is because a stock price falls to zero only
when there is no possibility that the company
would ever generate any future cash flows - an
option would be worthless.
Exercise Value vs. Option Price 2
The market price of the option is always
greater than or equal to the exercise value.
If the option price ever fell below the exercise
value, then you could buy the option and
immediately exercise it, reaping a riskless profit.
Because everyone would try to do this, the price
of the option would be driven up until it was at
least as high as the exercise value.
Exercise Value vs. Option Price 3
The market value of the option is greater than
zero even when the option is out-of-the-
money.
Depending on the remaining time until expiration
and the stocks volatility, there is a chance that the
stock price will rise above strike price, so the
option has value even if it is out-of-the-money.
Exercise Value vs. Option Price 4
The value of the option steadily increases as the stock price
increases.
The options expected payoff increases along with the stock price.
But as the stock price rises, the option price and exercise value
begin to converge (time value to gets smaller).
This happens because there is virtually no chance that the stock will
be out-of-the-money at expiration if the stock price is presently very
high. Thus, owning the option is like owning the stock, less the
exercise price.
The market price of the option also converges to the exercise value
if the option is about to expire.
With expiration close, there isnt much time for the stock price to
change, so the options time value would be close to zero for all stock
prices.
Exercise Value vs. Option Price 5
An option has more leverage than the stock.
If you buy STIs stock at $20 and it goes up to $30, you
would have a 50% return.
But if you bought the option instead, its price would
go from $8 to $16 versus the stock price increase from
$20 to $30. Thus, there is a 100% return on the
option.
If the stock price falls to $10, then you would have a
50% loss on the stock, but the option price would fall
to $2, leaving you with a 75% loss.
In other words, the option magnifies the returns on
the stock, for good or ill.
Exercise Value vs. Option Price 6
Options typically have considerable upside potential but
limited downside risk.
Suppose you buy the option for $8 when the stock price is $20.
If the stock price is $28 when the option expires, your net gain
would be $0:
Now suppose the stock price is either $50 or $5.
If its $50, your net gain is $30 - $8 = $22; if $5, your net loss is
still your $8 initial investment.
The payoffs from the option arent symmetric.
The most you can lose is $8, and this happens whether the stock
price at expiration is $20, $10, or even $1. On the other hand,
every dollar of stock price above $20 yields an extra dollar of
payoff from the option, and every dollar above $28 is a dollar of
net profit.
Additional factors
Options term to maturity
The longer a call option has to run, the greater its
value and the larger its time value.
Variability of the stock price
An option on an extremely volatile stock is worth
more than one on a very stable stock.
Option Pricing Models
The Binomial Approach
Riskless Hedge
Buy some shares of Stock X
Write a call option on the shares of Stock X
Receive payment from the call options purchaser
Assume an obligation to satisfy the purchaser if he or
she chooses to exercise the option.
Binomial Approach
We assume the stock price can take on only
one of two possible values at the end of each
period.
Stock W sells for $40 per share.
Call options for W at an exercise price of $35.
These options will expire at the end of one
year.
Step 1
Define the possible ending prices of the stock:
Lets assume that Ws stock will be selling at one of
two prices at the end of the year, either $50 or $32.
If there is a 70 % chance of the $50 price, then Ws
expected price is:
0.7($50) + 0.3($32) = $44.6
Because the current stock price is $40, W has an
expected return of :
($44.6 - $40)/$40 = 0.115 = 11.5%
If W were a riskier stock, then we would have
assumed different ending prices that had a wider
range and possibly a higher expected return.
Step 2
Find the range of values at expiration:
When the option expires at the end of the year, Ws stock will
sell for either $50 or $32, a range of $50 - $32 = $18.
The option will pay $15 if the stock is $50:
$50 - $35 = $15.
The option will pay ? if the stock price is $32:
Nothing, because this is below the exercise price.
The range of option payoffs is $15 - $0 = $15
The hedgers portfolio consists of the stock and the obligation
to satisfy the option holder, so the value of the portfolio in
one year is the stock price minus the option payoff.
Step 2
Step 3
Buy exactly enough stock to equalize the range of payoffs for
the stock and the option.
Range of payoffs for the stock is $18 and the range for the
option is $15.
To construct the riskless portfolio, equalize these ranges so
that the profits from the stock exactly offset the losses in
satisfying the option holder. We do so by buying $15/$18 =
0.8333 share and selling one option.
In this case, the current value of the stock in the portfolio is
$40(0.8333) = $33.33.
The value of the portfolios stock at the end of the year will be
either $50(0.8333) = $41.67 or $32(0.8333) = $26.67.
The range of the stocks ending value is now $41.67 - $26.67 =
$15.
Step 4
Step 4
Create a riskless hedged investment.
The call option that was sold will have no effect on the value
of the portfolio if Ws price falls to $32 because it will not be
exercisedit will expire worthless.
However, if the stock price ends at $50, the holder of the
option will exercise it. The option holders profit is the option
writers loss, so the option will cost the hedger $15.
Now note that the value of the portfolio is $26.67 regardless
of whether Ws stock goes up or down, so the portfolio is
riskless.
A hedge has been created that protects against both increases
and decreases in the price of the stock.
Step 5
Find the call options price.
The value of the portfolio will be $26.67 at the
end of the year, regardless of what happens to
the price of the stock.
This $26.67 is riskless, and so the portfolio should
earn the risk-free rate, which is 8%. If the risk-
free rate is compounded daily, the present value
of the portfolios ending value is:
Step 5
Because Ws stock is currently selling for $40,
and because the portfolio contains 0.8333
share, the value of the stock in the portfolio is
0.8333($40) = $33.33
In-class problem
Solution
The Binomial Lattice
6-Month Stock Prices and Option Values for
the 1st Section of the Binomial Lattice
Define the possible ending
prices of the stock

T is the time in years until the option expires

n is the number of steps per year
is the standard deviation
Black-Scholes Option Pricing Model

Assumptions of the Black-Scholes OPM

The stock underlying the call option provides no
dividends during the call options life.
There are no transactions costs for the
sale/purchase of either the stock or the option.
rRF is known and constant during the options life.
Black Scholes Assumptions (cont)
Security buyers may borrow any fraction of the
purchase price at the short-term risk-free rate.
No penalty for short selling and sellers receive
immediately full cash proceeds at todays price.
Call option can be exercised only on its expiration
date.
Security trading takes place in continuous time,
and stock prices move randomly in continuous
time.
3 equations of the Black-Scholes
OPM

V = P[N(d1)] - Xe -r t[N(d2)]
RF

ln(P/X) + [rRF + (2/2)]t

d1 =
t 0.5
d2 = d1 - t 0.5
3 equations of the Black-Scholes
OPM (cont)
What is the value of the following
call option according to the OPM?
Assume:
P = $27 (current price of the underlying stock)
X = $25 (exercise or strike price of the option)
rRF = 6% (risk-free interest rate)
t = 0.5 years (time until the option expires)
2 = 0.11 (variance of the rate of return on the
stock)
First, find d1 and d2.
d1 = {ln($27/$25) + [(0.06 + 0.11/2)](0.5)}
{(0.3317)(0.7071)}

d1 = 0.5736.

d2 = d1 - (0.3317)(0.7071)

d2 = 0.5736 - 0.2345 = 0.3391.

Second, find N(d1) and N(d2)
N(d1) = N(0.5736) = 0.7168.
N(d2) = N(0.3391) = 0.6327.

Note: Values obtained from Excel using

NORMSDIST function. For example:
N(d1) = NORMSDIST(0.5736)
Third, find value of option.

V = $27(0.7168) - $25e-(0.06)(0.5)(0.6327)
= $19.3536 - $25(0.97045)(0.6327)
= $4.0036.
In-class problem
Solution
Put Options
A put option gives its holder the right to sell a
share of stock at a specified stock on or before
a particular date.
Put-Call Parity
Portfolio 1:
Put option,
Share of stock, P
Portfolio 2:
Call option, V
PV of exercise price, X
Portfolio Payoffs for
P<X and PX
P<X PX
Port. 1 Port. 2 Port. 1 Port. 2
Stock P P
Put X-P 0
Call 0 P-X
Cash X X
Total X X P P
Put-Call Parity Relationship
Portfolio payoffs are equal, so portfolio values also
must be equal.
Put + Stock = Call + PV of Exercise Price

-rRFt
Put + P = V + Xe
-rRFt
Put = V P + Xe
In-class Problem
Solution