Financial Management

Lecture 4: Financial Options I

Professor Andrea Vedolin

ETH Zürich
 Today

Why do we study options in Corporate Finance?

Definitions

Terms of Option Contracts and Terminology

Interpreting Stock Option Quotations

Payoffs, Profits and Returns at Expiration

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 Why do we study options in Corporate Finance?

So far we discussed the tools a firm uses to make current investment decisions.
However, a firm has also the option to make future investments.

Importance of options for corporate financial managers:

Investment Decisions
ID financial investment opportunity: financial options
ID real investment decision making: real options
ID risk management: hedging with options and other derivatives

Financing Decisions
FD capital structure: equity and debt as options on the firm’s assets

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 Definition

Def.: A financial option is a contract that gives its owner the right (but not the
obligation) to buy or sell an asset at a fixed price at some future date.

2 fundamental types of option contracts:

call options
put options

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 Call Options
Def.: A call option is a contract that gives its owner the right
(but not the obligation) to buy an asset at a fixed price at some future date.

If you buy a call option written on IBM:

you pay the market price of the option (the “option premium”)
you are the buyer or “holder” of the contract: you have a “long position”
you have the option to “exercise the option”, that is the option to buy
IBM shares in the future for a pre-specified price (written in the contract).

If you sell a call option written on IBM:

you receive the market price of the option (the “option premium”)
you are the seller or “writer” of the contract: you have a “short position”
you have the obligation to sell IBM shares in the future for a pre-specified
price if the person you sold the option to wants to “exercise the option”, that
is wants to buy IBM shares.
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 Put Options
Def.: A put option is a contract that gives its owner the right
(but not the obligation) to sell an asset at a fixed price at some future date.

If you buy a put option written on IBM:

you pay the market price of the option (the “option premium”)
you are the buyer or “holder” of the contract: you have a “long position”
you have the option to “exercise the option”, that is the option to sell IBM
shares in the future for a pre-specified price (written in the contract).

If you sell a put option written on IBM:

you receive the market price of the option (the “option premium”)
you are the seller or “writer” of the contract: you have a “short position”
you have the obligation to buy IBM shares in the future for a pre-specified
price if the person you sold the option to wants to “exercise the option”, that
is wants to sell IBM shares.
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 Terms of Option Contracts and Notation

underlying asset: asset on which the option is written

underlying price (St ): price at time t of the underlying asset
expiration date (T ): date after which the option can not be exercised
exercise or strike price (K ): fixed price set at time 0 at which the
underlying asset can be purchased or sold if the option is exercised
option price or premium or cost (call:C0 , put: P0 ): price the buyer has to
pay to the seller of the option at time 0
option payoff (call: CT , put: PT ): monetary value of what the buyer of the
option receives at the expiration date upon exercise
exercise style: defines when the holder can exercise the option
I European: only at expiration date T
I American: any time t between the purchase of the option and the expiration
date, 0 6 t 6 T
I Guideline: most traded options are American, but options on stock indices,
such as the S&P 500, are typically European

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 Interpreting Stock Option Quotations

STRIKE PRICES

Last sale: last sale price at which the option was traded
Net: net change from the previous day’s last reported sale price
Ask price: price at which the option can be purchased
Bid price: price at which the option can be sold
Volume: total daily volume
Open Interest: the total number of outstanding contracts of an option
Note: Stock option contracts are always written on 100 shares of stock.
Options expire on the Saturday following the third Friday of the month.
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 Option “Moneyness”
At any point in time t, an option is:

either at-the-money: when the payoff would be 0 if immediately exercised

I St = K

or in-the-money: when the payoff would be positive if immediately exercised

I call option: St > K (buy at K something that is worth more than K )
I put option: St < K (sell at K something that is worth less than K )

or out-of-the-money: when the payoff would be negative if immediately

exercised
I call option: St < K (buy at K something that is worth less than K )
I put option: St > K (sell at K something that is worth more than K )

When the strike price K and the underlying price St are very far apart, we use the
expressions deep in-the-money or deep out-of-the-money.

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 Example 1
It is July 8, 2009 and you have decided to purchase 10 August call contracts on
Amazon stock with an exercise price of $80. How much money will this purchase
cost you? Is this option in-the-money or out-of-the-money?

Total cost: $4.00 × 10 × 100 = $4, 000

Since the exercise price (K = $80) is above the current underlying stock price
(St = $77.03) ⇒ the option is currently out-of-the-money

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 Example 2
It is July 8, 2009 and you have decided to purchase 15 August put contracts on
Amazon stock with an exercise price of $85. How much money will this purchase
cost you? Is this option in-the-money or out-of-the-money?

Total cost: $10.40 × 15 × 100 = $15, 600

Since the exercise price (K = $85) is above the current underlying stock price
(St = $77.03) ⇒ the option is currently in-the-money

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 Example 3
Although most traded options are American, options on stock indices, such as the
S&P 500, are typically European

What do we observe in this quotation table?

Why do we see this?

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 Example 3

Because index options are European-style, it is possible for the option’s price
to be below its intrinsic value, so that its time value is negative.
I Calls with strikes of 1400 or below
I Puts with strikes of 3400 or above
For the deep in-the-money calls, the dividends are larger than the interest
earned on the low strike prices, making it costly to wait to exercise the option
For the deep in-the-money puts, the interest on the high strike prices exceeds
the dividends earned, again making it costly to wait
This is why we will consider early exercise if American options next time

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 Option Payoffs (Cash-flows) at Expiration
Long position in a Call Option:

If I exercise, I pay K for something worth ST : hence I would get (ST − K )

If ST > K ⇒ I do exercise and I get (ST − K ) > 0
If ST < K ⇒ I do not exercise and I get 0
Payoff at expiration: max(ST − K, 0) ⇒ always positive

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 Option Payoffs (Cash-flows) at Expiration
Short position in a Call Option:

I am obliged to take the other side of the transaction if the holder exercises
If ST > K ⇒ the holder does exercise and I get (K − ST ) < 0
If ST < K ⇒ the holder does not exercise and I get 0
Payoff at expiration: −max(ST − K, 0) ⇒ always negative

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 Option Payoffs (Cash-flows) at Expiration
Long position in a Put Option:

If I exercise, I sell something worth ST for K : hence I would get (K − ST )

If ST > K ⇒ I do not exercise and I get 0
If ST < K ⇒ I do exercise and I get (K − ST ) > 0
Payoff at expiration: max(K − ST , 0) ⇒ always positive

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 Option Payoffs (Cash-flows) at Expiration
Short position in a Put Option:

I am obliged to take the other side of the transaction if the holder exercises
If ST > K ⇒ the holder does not exercise and I get 0
If ST < K ⇒ the holder does exercise and I get (ST − K ) < 0
Payoff at expiration: −max(K − ST , 0) ⇒ always negative

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 Long vs Short Position
Since a long position in a call or a put option is always associated with a
positive (strictly > 0 or 0) payoff at expiration...

...and since a short position in a call or a put option is always associated with a
negative (strictly < 0 or 0) payoff...

Why would you ever take a short position (sell an option)?

⇓

Because the seller of an option receives the option price at time 0!

Therefore, let’s consider the profits for holding an option to expiration...

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 Profits for Holding an Option to Expiration
Long position in a Call Option:

At time 0 I pay −C0

At time T I get max(ST − K , 0)
Profits at time T (FV of cash-flows): max(ST − K, 0) − C0 (1 + r)T

Example 1 (red line). 09 Aug 80 Call: max(ST − 80, 0) − 4.00(1 + 3%)45/365

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 Profits for Holding an Option to Expiration
Long position in a Put Option:

At time 0 I pay −P0

At time T I get max(K − ST , 0)
Profits at time T (FV of cash-flows): max(K − ST , 0) − P0 (1 + r)T

Example 2 (purple line). 09 Aug 85 Put: max(85 − ST , 0) − 10.40(1 + 3%)45/365

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 Returns for Holding an Option to Expiration

max(ST −K , 0) max(K −ST , 0)

Returncall = C0 −1 Returnput = P0 −1

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