Introduction to Corporate Finance

Prepared by Ying Pan Tong Niu Charlie Giurleo I.Murat Coskun

Options

Introduction Basic concept

- History & Revolution - Current markets & Regulator - Characteristics & Terminology

Types of Options
- Call options - Put options

Valuation

- Payoff method - Binomial tree method

Strategies

- Bullish strategy - Bearish strategy - Neutral strategy

Q&A & REWARDS!

Options 2

House selling at $1M

Option Contract @ $10,000

Seller (Writer)

Buyer (Holder)

Options

Scenario #1

House now selling at $2M () $2,000,000 $1,000,000 - $10,000 $990,000 (Profit) Buyer (Holder)

Option Contract @ $10,000

Seller (Writer)

Options

Scenario #2

House now selling at $100K () Option Contract @ $10,000

$10,000 ($10,000) (Loss)

Seller (Writer)

Buyer (Holder)

Options

History
- Ancient Greek philosopher and mathematician Thales of Miletus - Purchased the Right to rent numerous olive presses before a predicted increase in olive harvest - Fortunately, his prediction was right - Exercised his Right to rent out all presses!

Options

Revolution
- London engaged in Puts and Refusals (Calls) in 1690:
- investors have the right to convert the bond into a common stock
- issuers of the bond have the right to buy back the bond at a specified price

- In 19th century of North America, Privileges were sold,

which combine a call and a put on a selected share, expired usually within 3 months

Options

Current Markets & Regulator

-

Major markets over the world:

In Canada, options are traded on the Montreal Exchange and are cleared through the Canadian Derivatives Clearing Corp(CDCC) The CDCC stands between option buyers and option sellers (writers).

Options

Option is a contract
Two parties: Seller (also called writer) Buyer (also called holder)
- The seller sells an Option contract to the buyer, accepts a premium and assumes the obligation that is specified in the contract - The buyer pays premium to the seller and gets the option or choice or right to buy the underlying asset from the seller during a particular period of time CALL BUYER (Long) Right to Buy PUT Right to Sell

SELLER (Short)

Obligation to Sell Obligation to Buy

Options

Terminology
Call Option (or Calls): the right but not the obligation to buy an underlying asset during a particular period of time Put Option (or Puts): the right but not the obligation to SELL an underlying asset during a particular period of time

A put option is the opposite of a call option

Options

10

Terminology
Exercise the option: invoke the rights contracted Exercising price (or striking price): the price at which the buyer can purchase or sell the underlying instrument Expiration date: the date at which the rights to exercise the option cease to exist Option premium: the price of an option In-the-money, out-of-the-money: making a profit vs. not

Options

11

Characteristics
Trading Platform: - Listed: openly traded in exchange market - Over-the-counter: between two private parties Exercise Types: - American: the right could be exercised any date before the expiration date - European: the right could be exercised only on the day of expiration date Underlying assets : - Usual assets, common shares, commodities, rare metals, interest rates, exchange rates, etc.

Options

12

Buying a call from the Buyers perspective

The buyer speculates the stock price will go up, then buy a call option by paying the option price (premium). If the stock price goes up during the expiration period, the buyer exercises the option and earns the profit. As illustrate in the table, the stock price goes up from $80 to $100, the call option buyer earns $11($20 minus $9 of option price ).
Striking Price 80 Stock Expiration Price Date 100 July P/C C 9 Option Price Option Value 20
Options

Net Profit 11
13

Payoff from the buying a call

Striking Price 80

Stock Expiration Price Date 100 July

P/C C 9

Option Price

Option Value 20
Options

Net Profit 11
14

Selling a call from the Sellers perspective

The seller will get the premium whenever he/she sells a call option. If the stock price does not go up by the expiration, the call buyer will not exercise the option and the seller can get the premium as a net profit.
If the stock price goes up and the buyer exercises the option, then the seller have to assume the obligation to sell the stock with the exercise price and bear a loss which equal is to the buyers net profit. In the example above, $11 is sellers net loss and buyers net profit
Striking Price 80 Stock Expiration Price Date 100 July P/C C 9 Option Price
Options

Option Value 20

Net Profit 11
15

Payoff from writing a call.

Striking Price 80

Stock Expiration Price Date 100 July

P/C C 9

Option Price

Option Value 20
Options

Net Profit 11
16

Buying a put from the buyers perspective

The buyer speculates the stock price will go down, then buy a put option by paying the option price (premium). If the stock price goes down by the expiration, the buyer exercises the option and earns the profit. As illustrate in the table, the stock price goes down from $85 to $75, the call option buyer earns $10 minus $5 of option price and get $5 net profit.
Striking Price 85 Stock Expiration Price Date 75 Aug P/C P 5 Option Price Option Value 10
Options

Net Profit 5
17

Payoff from buying a put.

Striking Price 85

Stock Expiration Price Date 75 Aug

P/C P 5

Option Price
Options

Option Value 10

Net Profit 5
18

Selling a put from the sellers perspective

The seller will get the premium whenever he/she sells a put option. If the stock price does not go down by the expiration, the put buyer will not exercise the option and the seller can get the premium as a net profit.
If the stock price goes down and the buyer exercises the option, then the seller have to assume the obligation to sell the stock with the exercise price and bear a loss which equal to the buyers net profit. In the example above, $5 is sellers net loss and buyers net profit
Striking Price 85 Stock Expiration Price Date 75 Aug P/C P 5 Option Price Option Value 10
Options

Net Profit 5
19

Payoff from writing a put.

Striking Price 85

Stock Expiration Price Date 75 Aug

P/C P 5

Option Price

Option Value 10

Net Profit 5
20

Options

Call option value= Stock value - PV of the exercise price

C0=S0 -E/(1+Rf)t

5 key variables:

1) Current stock price (S0)

2) Exercise price of the option (E) 3) Time of expiration (t) 4) Risk free rate (Rf) 5) Variance of return on stock
Options 21

You would like to purchase a 1 year call option for RBC stock- the exercise price= $45 per share and the stock price is currently at $70 and the risk free rate=2% and you speculate that the stock will be between $60 and $80 in 1 year.

What is the cost of the option?

Options

22

S0 =70 . E=45 Rf=2% & t=1

t=0

Both speculated stock prices are in the money, therefore:

t=1

S0 =70

E= $45

discount E 1 yr C0=S0 -E/(1+Rf)t = 70- (45/1.02)1= 25.88 Therefore call option = $25.88
Options 23

You would like to purchase a 1 year call option for RBC stock- the exercise price= $45 per share and the stock price is currently at $70 The risk free rate=2% and you speculate that the stock will be between $40 and $80 in 1 year.

What is the cost of the option?

Options

24

Call option calculation S0 =70, E=45, Rf=2% & t=1 therefore:

The option can finish out of the $ and be worth 0 at expiration or in the $ and be worth $35
When the stock finishes at $80, our riskfree asset pays $40, leaving us $40 short. Each option is worth $35 in this case, so we need $40/$35 = 1.14options to match the payoff on the stock.
Options

25

We must now invest $40 in a risk free asset and in 1.14call options
End price 1
(S1+-S1-)/(S1+-E)= C0 ratio
80-40/(80-45)=1.14

Stock price S0=$70

S1+=$80
End price 2 S1-=$40

PV of S140/1.02

40 S0 1.14 C0 (1 R f )

40 70 1.14 C0 (1.02 )

C0 $27.00
Options 26

Call option calculation S0 =70, E=45, Rf=2% & t=1 therefore:

C1+=max(0,Price-Strike) C1+=max(0,80-45) C1+=$35 C1-=max(0,Price-Strike) C1-=max(0,40-45) C1-=$0

End price 1

Stock price$70

$80
End price 2 $40

For this case assume a 50% probability for both outcomes

Options 27

E (call option value in 1 year)= ($35x.5)+($0x.5) = $17.50

$17.50 C0 $17.16 1.02

Therefore value of call option is $17.16

Options

28

- Develops tailored to investor characteristics - Multiple variables that matter in the strategy: - Investment Goals - Anticipation on the underlying asset movement - Risk Level - Widely used for hedging (as an insurance tool) - Numerous established strategies out there

Options

29

Options

30

Types: - Bullish Strategies

- Bearish Strategies
- Neutral Strategies

Options

31

- Trader expects underlying asset price to go up - Assess: how high & time frame - Most bullish strategy - Example: Simple Call Buying Strategy - Moderate: target price for the bull run & utilize bull spreads to reduce cost - Maximum profit is capped - Example: Bull Call Spread & Bull Put Spread - Mildly bullish strategies: make money as long as the underlying stock price does not go down by the expiration date - Example: Writing Out-of-the-Money Covered Calls
Options 32

- Trader expects underlying asset price to go down - Assess: how low & time frame - Most bearish strategy - Example: Simple Put Buying Strategy - Moderate: target price for the expected decline & utilize bear spreads to reduce cost - Maximum profit is capped - Example: Bear Call Spread & Bear Put Spread - Mildly bullish strategies: make money as long as the underlying stock price does not go up by the expiration date

Options

33

- Trader does not know what movement to expect for the underlying asset price - Also called non-directional strategies: profit does not depend on underlying stock price going up or down - Correct neutral strategy to employ depends on the expected volatility of the underlying stock price - Examples: - Straddle: position in a call & a put at the same strike & expiration - Strangle: simultaneous buying or selling of out-of-the-money
put & call with same expirations yet different strike prices two at the money calls or vice versa

- Butterfly: buy in-the-money and out-of-the-money call & sell - Guts: sell in the money put and call
Options 34

Q&A

Options

35

A call option is:

a) the obligation to BUY an underlying asset during a particular period of time b) the right to BUY an underlying asset during a particular period of time c) the right to SELL an underlying asset during a particular period of time d) the obligation to SELL an underlying asset during a particular period of time

Options

36

What should a trader who believes that a stock's price will decrease do?
1) buy a call 3) write a call 2) buy a put 4) write a put

a) 2 only b) 3 only c) both 1&4 d) both 2&3

Options

37

Which of the following option(s) could ONLY be exercised on the date of expiration?

a) American option b) European option c) Bermuda option d) all of these above

Options

38

Which of the following best completes the below statement?

An option trader exercises a bullish strategy when he/she expects

a) the market to go up in movement b) the long call to overlap the short call c) the underlying asset to go up in movement d) the prices of bovine animals to go up in the near future

Options

39

References: TradeKing.com Covered Call Options Strategy. <http://www.youtube.com/watch?v=UT6Y4OZ_Ejc> OptionsPhysics.com Straddles and Strangles. <http://www.youtube.com/watch?v=HPHs7UsjBmY&NR=1> The Options Guide Options & Futures Trading Explained <http://www.theoptionsguide.com/> About.com <http://daytrading.about.com/b/2007/11/18/options-trading-basic-options-strategies.htm> OptionsTradingGuide.com <http://www.option-trading-guide.com/spreads.html> The Options Industry Council Strategies <http://www.optionseducation.org/strategy/default.jsp> Barrie, Scott (2001). The Complete Idiot's Guide to Options and Futures. Alpha Books. pp. 120121. InvestorWords.com Index Options. < http://www.investorwords.com/2431/index_option.html > OIC< http://www.optionseducation.org/basics/leaps/default.jsp > Index Options. InvestorWords.com, March 18, 2011 Option (finance), Wikipedia, modified on 15 March 2011 at 23:34, < http://en.wikipedia.org/wiki/Option_(finance) > Options Basics: Types of options. Investopedia.com, March 18, 2011 < http://www.investopedia.com/university/options/option3.asp > Black, F. and Myron, S. The Pricing and Corporate Liabilities. Journal of Political Economy, 81, 637-659 Cox, J. C., Ross, S.A. and Rubinstein, M. (1979). Option Pricing: A Simplified Approach. Journal of Financial Economics, 7, 229-263 Dixit, A. K. and Pindyck, R.S.(1995). The Options Approach to Capital Investment. Harvard Business Review, 73, 105---115. Dale Jackson, BNN Producer 3:32 pm, E.T. February 17,2011 Canadian <http://www.bnn.ca/Blogs/2011/02/17/It-may-be-time-for-alternativethinking.aspx> Call Options Trading for Beginners - Put and Call Options Explained <http://www.youtube.com/watch?v=q_z1Zx_BALo> Ross S.A., Westerfield R.W., Jordan B.D., Roberts G.S., (2010) Fundamentals of Corporate Finance, Seventh Canadian Edition. Canada: McGrawHill Ryerson Kaplan Schweser Faculty (2010). Chartered Financial Analyst Level 2, Book 5, Derivatives and portfolio management. La Crosse, WI, United States: Kaplan Berk J.,DeMarzo P.M.,Stangeland D.,(2010) Corporate Finance, Canadian Edition, Canada: Pearson Education Canada

Options

40

Backup Slides

Options

41

Covered Call Strategy

Three main steps: (1) Purchase the Stock (2) Sell a Single Call Contract (3) Wait for Call to be Exercised or Expired to Realize Profit
Risk: no protection if stock price goes down Loss = Purchase Price of Stock Price of Stock Premium Received Maximum Profit = Limited Profit = Strike Price Purchase Price of Stock + Premium Received

Options

42

Straddle Strategy
Main steps: (1) Buy both a call & a put at the same strike price with same expiration (2) As the trade begins to move in one direction, trader sell the other
When: trader does not have a clear sense of which direction stock price will move Goal: underlying stock moves far enough & winning leg of the position makes more money than the losing leg costs.

Options

43

Strangle Strategy
Main steps: (1) Buy both a call & a put at the same with same expiration, but different strike prices (2) As the trade begins to move in one direction, trader sell the other
When: trader does not have a clear sense of which direction stock price will move, but believes the stock is highly volatile Goal: underlying stock moves far enough & winning leg of the position makes more money than the losing leg costs. Limited Risk: cost of both options may be lost

Options

44

Call Spread
Four main steps: (1) Purchase a single at money call contract (2) Sell a single in money call contract (3) Wait for the price to move above the long call strike price plus the long call premium (4) Exercise the long call to realize profit
Low Risk: limited to initial debit taken at entering the trade regardless of how far price moves down Maximum Risk = Initial Debit Loss = Long Call Premium Short Call Premium Maximum Profit = Short Call Strike Price Long Call Strike Price Initial Debit Profit = Stock Price Upon Expiration Long Call Strike Price Options Initial Debit
45

Put Spread
Four main steps: (1) Purchase a single at money put contract (2) Sell a single in money put contract (3) Wait for the price to move above the short put strike price (4) Let both puts expire worthless
Maximum Risk: Difference between long and short put strike prices Initial Credit Loss = Short Put Strike Price Long Put Strike Price - Initial Credit Maximum Profit = Initial Credit Profit = Short Put Premium Long Put Premium
Options 46

Long call

Payoff from buying a call.

Options

47

A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can control (leverage) a much larger number of shares

Options

48

Other options

Insurance
Loan guarantees
The right to collect from a third party (often a governmental institution) if the borrower defaults

Employee stock options

Incentive form of compensation awarded by the corporation to employees, as the stock price increase, employees realize profit on either selling the stock or purchase the share at a lower prefixed price.

Options

49

Other options

Real options
An option with payoffs in real goods

Index options (stocks market index options)

With an index as underlying security, the settlement is made by cash payment if the option is exersiced.

LEAPS (Long-Term Equity AnticiPation Securities )

Options for investors who prepare to carry the position in long term of period.

Options

50

Other options

The call provision on the bond

Held by the corporation, gives the corporation the right to call back the bond at a fixed price for a fixed time period

Put bonds
Gives the holder of the bond the right to force the issuer to repurchase the bond at a fixed price for a fixed period of time

The overallotment options

Gives the underwriters of an IPO the right to purchase additional shares of stock of the firm

Options

51