Options (2)

Class 20

Financial Management, 15.414

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 20

Today

Options

• Option pricing

• Applications: Currency risk and convertible bonds

Reading

• Brealey and Myers, Chapter 20, 21

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 20

Options

Gives the holder the right to either buy (call option) or sell (put
option) at a specified price.

Exercise, or strike, price

Expiration or maturity date

American vs. European option

In-the-money, at-the-money, or out-of-the-money

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 20

Option payoffs (strike = $50)

25
25

20
20

Buy a call Buy a put

15
15

10
10

5
5

0 0
30 40 50 60 70 30 40 50 60 70
-5 -5
Stock price Stock price

5 5
Stock price Stock price
0 0
30 40 50 60 70 30 40 50 60 70
-5 -5

-10 -10
Sell a call Sell a put
-15 -15

-20 -20

-25 -25

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15.414 Class 20

Valuation

Option pricing

How can we estimate the expected cashflows, and what is the

appropriate discount rate?

Two formulas

Put-call parity

Black-Scholes formula*

* Fischer Black and Myron Scholes

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15.414 Class 20

Put-call parity

Relation between put and call prices

P + S = C + PV(X)

S = stock price
P = put price
C = call price
X = strike price
PV(X) = present value of $X = X / (1+r)t
r = riskfree rate

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 20

Option strategies: Stock + put

70 25
65
20
60
55
Buy stock 15
50 Buy put
10
45
40 5
35
0
30 30 40 50 60 70
30 40 50 60 70 -5
Stock price Stock price

70
65
60
55
50
45
40 Stock + put
35
30
30 40 50 60 70
Stock price

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 20

Option strategies: Tbill + call

70 25
65
60
Buy Tbill with 20

55 FV = 50 15
50 Buy call
10
45
40 5
35
0
30 30 40 50 60 70
30 40 50 60 70 -5
Stock price Stock price

70
65
60
55
50
45
40 Tbill + call
35
30
30 40 50 60 70
Stock price

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 20

Example

On Thursday, Cisco call options with a strike price of $20 and an

expiration date in October sold for $0.30. The current price of Cisco
is $17.83. How much should put options with the same strike price
and expiration date sell for?

Put-call parity

P = C + PV(X) – S

C = $0.30, S = $17.83, X = $20.00

r = 1% annually → 0.15% over the life of the option

Put option = 0.30 + 20 / 1.0015 – 17.83 = $2.44

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15.414 Class 20

Black-Scholes

Price of a call option

C = S × N(d1) – X e-rT N(d2)

S = stock price
X = strike price
r = riskfree rate (annual, continuously compounded)
T = time-to-maturity of the option, in years
ln(S/X) + (r + σ2 /2) T
d1 =
σ T
d2 = d1 − σ T
N(⋅) = prob that a standard normal variable is less than d1 or d2
σ = annual standard deviation of the stock return

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15.414 Class 20

Cumulative Normal Distribution

0.5
N(-2) = 0.023
N(-1) = 0.159
0.4 N(0) = 0.500
N(1) = 0.841
N(2) = 0.977
0.3

0.2

0.1

0.0
-3.5 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5

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15.414 Class 20

Example

The CBOE trades Cisco call options. The options have a strike price
of $20 and expire in 2 months. If Cisco’s stock price is $17.83, how
much are the options worth? What happens if the stock goes up to
$19.00? 20.00?

Black-Scholes

S = 17.83, X = 20.00, r = 1.00, T = 2/12, σ2003 = 36.1%

ln(S/X) + (r + σ2 /2)
T
d1 = = -0.694

σ T

d2 = d1 − σ T = -0.842

Call price = S × N(d1) – X e-rT N(d2) = $0.35

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 20

Cisco stock price, 1993 – 2003

$90
80
70
60
50
40
30
20
10
0
Aug- Aug- Aug- Aug- Aug- Aug- Aug- Aug- Aug- Aug-
93 94 95 96 97 98 99 00 01 02

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15.414 Class 20

Cisco returns, 1993 – 2003

40%

30%

20%

10%

0%
Aug-93

Aug-94

Aug-95

Aug-96

Aug-97

Aug-98

Aug-99

Aug-00

Aug-01

Aug-02
-10%

-20%

-30%

-40%

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15.414 Class 20

Cisco option prices

$6
Payoff (intrinsic value)
5
Today's price (2 months)

4
Option price

0
15 16 17 18 19 20 21 22 23 24 25
Stock price

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15.414 Class 20

Option pricing

Factors affecting option prices

Call option Put option

Stock price (S) + –

Exercise price (X)
Time-to-maturity (T)
Stock volatility (σ)
Interest rate (r)
Dividends (D)
– +
+ +
+ +
+ –
– +

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15.414 Class 20

Example 2

Call option with X = $25, r = 3%

Time to expire Stock price Std. deviation Call option
$18 30% $0.02
25 30 1.58
32 30 7.26
T = 0.25
18 50 0.25
25 50 2.57
32 50 7.75
18 30 0.14
25 30 2.29
32 30 7.68
T = 0.50
18 50 0.76
25 50 3.67
32 50 8.68

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15.414 Class 20

Option pricing

18
16 0 months

14
1 month
3 months
12
Option price

6 months
10
8
6
4
2
0
9 13 17 21 25 29 33 37 41
Stock price

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15.414 Class 20

Using Black-Scholes

Applications

Hedging currency risk

Pricing convertible debt

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15.414 Class 20

Currency risk

Your company, headquartered in the U.S., supplies auto parts to

Jaguar PLC in Britain. You have just signed a contract worth ₤18.2
million to deliver parts next year. Payment is certain and occurs at
the end of the year.

The $ / ₤ exchange rate is currently s$/₤ = 1.4794.

How do fluctuations in exchange rates affect $ revenues? How can

you hedge this risk?

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15.414 Class 20

s$/₤, Jan 1990 – Sept 2001

2.1
Volatility
Full sample: 9.32%
1.95 After 1992: 8.34%
After 2000: 8.33%
After 2001: 7.95%
1.8

1.65

1.5

1.35

1.2
J-90 J-91 J-92 J-93 J-94 J-95 J-96 J-97 J-98 J-99 J-00 J-01

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15.414 Class 20

$ revenues as a function of s$/₤

$ 32

30

28
$26.9 million

26

24

22

20
1.30 1.34 1.38 1.42 1.46 1.50 1.54 1.58 1.62 1.66
Exchange rate

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15.414 Class 20

Currency risk

Forwards

1-year forward exchange rate = 1.4513

Lock in revenues of 18.2 × 1.4513 = $26.4 million

Put options*

S = 1.4794, σ = 8.3%, T = 1, r = -1.8%*

Strike price Min. revenue Option price Total cost (×18.2 M)

1.35 $24.6 M $0.012 $221,859
1.40 $25.5 M $0.026 $470,112
1.45 $26.4 M $0.047 $862,771

*Black-Scholes is only an approximation for currencies; r = rUK – rUS

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15.414 Class 20

$ revenues as a function of s$/₤

$31
30
with put option
29
28
27 with forward contract
26
25
24
23
22
1.30 1.34 1.38 1.42 1.46 1.50 1.54 1.58 1.62 1.66
Exchange rate

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 20

Convertible bonds

Your firm is thinking about issuing 10-year convertible bonds. In the

past, the firm has issued straight (non-convertible) debt, which
currently has a yield of 8.2%.

The new bonds have a face value of $1,000 and will be convertible
into 20 shares of stocks. How much are the bonds worth if they pay
the same interest rate as straight debt?

Today’s stock price is $32. The firm does not pay dividends, and
you estimate that the standard deviation of returns is 35% annually.
Long-term interest rates are 6%.

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15.414 Class 20

Payoff of convertible bonds

$ 1,500
1,400 Convertible into 20 shares
1,300 Convert if stock price > $50
1,200 (20 × 50 = 1,000)
1,100
1,000
900
800
700
600
500
30 34 38 42 46 50 54 58 62 66 70

Stock price

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15.414 Class 20

Convertible bonds

Suppose the bonds have a coupon rate of 8.2%. How much

would they be worth?

Cashflows*

Year 1 2 3 4 … 10

Cash $82 $82 $82 $82 $1,082

Value if straight debt: $1,000

Value if convertible debt: $1,000 + value of call option

* Annual payments, for simplicity

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15.414 Class 20

Convertible bonds

Call option

X = $50, S = $32, σ = 35%, r = 6%, T = 10

Black-Scholes value = $10.31

Convertible bond

Option value per bond = 20 × 10.31 = $206.2

Total bond value = 1,000 + 206.2 = $1,206.2

Yield = 5.47%*

*Yield = IRR ignoring option value

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