23- 1

McGraw Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Fundamentals
of Corporate
Finance

Sixth Edition
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
Slides by
Matthew Will
Chapter 23
McGraw Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Options
23- 2
Topics Covered
Calls and Puts
What Determines Option Values?
Spotting the Option
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.
23- 4
Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
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 $720
0 0 0 60 120 Value Put
120 60 0 0 0 Value Call
840 780 720 660 $600 Price Stock
23- 6
Option Value
Call option value (graphic) given a $720 exercise price.
Share Price
C
a
l
l

o
p
t
i
o
n

v
a
l
u
e

720 840
$120
23- 7
Option Value
Put option value (graphic) given a $720 exercise price.
Share Price
P
u
t

o
p
t
i
o
n

v
a
l
u
e

600 720
$120
23- 8
Option Value
Call option payoff (to seller) given a $720 exercise price.
Share Price
C
a
l
l

o
p
t
i
o
n

$

p
a
y
o
f
f

720
23- 9
Option Value
Put option payoff (to seller) given a $720 exercise price.
Share Price
P
u
t

o
p
t
i
o
n

$

p
a
y
o
f
f

720
23- 10
Option Value
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Protective Put
Long Put
Long Stock
23- 11
Option Value
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Protective Put
23- 12
Option Value
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Straddle
Long put
Long call
23- 13
Option Value
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Straddle
23- 14
Option Value
Call buyer profit assume strike of $720 and
option price of $80.50
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Long call
720 800.50
-80.50
Break even
23- 15
Option Value
Put seller profit assume strike of $720 and option
price of $71.20
Share Price
P
o
s
i
t
i
o
n

V
a
l
u
e

Short put
648.80 720
+71.20
Break even
23- 16
Option Value
Stock Price
Upper Limit
Lower Limit
(Stock price - exercise price) or 0
which ever is higher
23- 17
Option Value
23- 18
Option Value
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 always exceeds its
minimum value (except at maturity or when stock
price is zero).

The value of an option increases with both the variability of
the share price and the time to expiration.
23- 19
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)
23- 20
Option Value
Black-Scholes Option Pricing Model
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
23- 21
Options on Real Assets
Real Options - Options embedded in real assets
23- 22
Options on Real Assets
Real Options - Options embedded in real assets
Option to Expand
Option to Abandon
23- 23
Options on Financial Assets
Executive Stock Options Long term call options
given to executives as part of their compensation
package.
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.