Financial Options And Applications In Corporate Finance

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Chapter 8
Financial Options and
Applications in Corporate
Finance
1

Topics in Chapter





Financial Options Terminology
Option Price Relationships
Black-Scholes Option Pricing Model
Put-Call Parity

2

The Big Picture:
The Value of a Stock Option
Cost of equity (rs)

D1
Stock Price =
(1 + rs )1

Risk-free bond

Dividends
(Dt)

D2
+
(1 + rs)2

Portfolio of stock and risk-free bond that replicates cash flows of the option

... +

D∞
+
(1 + rs)∞

Value of option must be the same as the replicating portfolio

3

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.

4

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.

5

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. 6

Option Terminology




Strike (or exercise) price: The price stated in the option contract at which the security can be bought or sold.
Expiration date: The last date the option can be exercised.

7

Option Terminology
(Continued)


Exercise value: The value of a call option if it were exercised today =






Max[0, Current stock price - Strike price] Note: The exercise value is zero if the stock price is less than the strike price. Option price: The market price of the option contract.
8

Option Terminology
(Continued)


Time value: Option price minus the exercise value. It is the additional value because the option has remaining time until it expires.

9

Option Terminology
(Continued)


Writing a call option: For every new option, there is an investor who
“writes” the option.




A writer creates the contract, sells it to another investor, and must fullfill the option contract if it is exercised.
For example, the writer of a call must be prepared to sell a share of stock to the investor who owns the call.
10

Option Terminology
(Continued)




Covered option: A call option written against stock held in an investor’s portfolio.
Naked (uncovered) option: An option written without the stock to back it up.

11

Option Terminology
(Continued)




In-the-money call: A call whose strike price is less than the current price of the underlying stock.
Out-of-the-money call: A call option whose strike price exceeds the current stock price.

12

Option Terminology
(Continued)


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
½ years.

13

Consider the following data: Strike 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
14

Exercise Value of Option
Price of stock (a)

Strike price (b)

Exercise value of option (a)–(b)

$25.00
30.00
35.00
40.00
45.00
50.00

$25.00
25.00
25.00
25.00
25.00
25.00

$0.00
5.00
10.00
15.00
20.00
25.00
15

Market Price of Option
Price of Strike
Exer. Mkt. Price stock price val. (c) of opt. (d)
(a)
(b)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00
12.00
40.00
25.00 15.00
16.50
45.00
25.00 20.00
21.00
50.00
25.00 25.00
25.50
16

Time Value of Option
Price of Strike
Exer.
Mkt. P of stock price Val. (c)
(a)
(b) opt. (d)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00 12.00
40.00
25.00 15.00 16.50
45.00
25.00 20.00 21.00
50.00
25.00 25.00 25.50

Time value (d) – (c)
$3.00
2.50
2.00
1.50
1.00
0.50
17

Call Time Value Diagram
Option value

30
25
20
Market price

15
Exercise value

10
5

5

10

15

20

25

30

35

40

18

Stock Price

Option Time Value Versus
Exercise Value




The time value, which is the option price less its exercise value, declines as the stock price
Show More

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