Chapter 21

Option Applications & Corporate Finance

Option Basics
Financial Option
A contract that gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date
Call options Put options

Option Basics
Option Contracts
Terms:
Derivatives Option Buyer/Option Holder
Long Position

Option Seller/Option Writer

Short Position

Exercising The Option Strike Price/Exercise Price Expiration Date American Options European Options

The Language of Options

Option Basics
Stock Option Quotations
At-The-Money In-The-Money
Deep In-The-Money

Out-Of-The-Money
Deep Out-Of-The-Money

Open Interest

Option Quotes for Amazon.com Stock

Option Basics
Options on Other Financial Securities
Hedging Speculating

Option Payoffs at Expiration

The Long Position in an Option Contract
When the stock price on the expiration date exceeds the strike price, the value of the call is the difference between the stock price and the strike price When the stock price is less than the strike price at expiration, the holder will not exercise the call, so the option is worth nothing

Payoff of a Call Option with a Strike Price of $20 at Expiration

Option Payoffs at Expiration

Call Value at Expiration
Call Value = Stock Price Strike Price, if Stock Price > Strike = 0, if Stock Price Strike

Put Price at Expiration

Put Value = Strike Price Stock Price, if Stock Price < Strike = 0, if Stock Price Strike

Option Payoffs at Expiration

The Short Position in an Option Contract
An investor holding a short position in an option has an obligation The short positions cash flows are the negative of the long positions cash flows Because an investor who is long an option can only receive money at expiration, a short investor can only pay money

Short Position in a Call Option at Expiration

Option Payoffs at Expiration

Profits for Holding an Option to Expiration
Although payouts on a long position in an option contract are never negative, the profit from purchasing an option and holding it to expiration could be negative
The payout at expiration might be less than the initial cost of the option

Profit from Holding a Call Option to Expiration

Factors Affecting Option Prices

Strike Price and Stock Price
For a given strike price, the value of a call option increases as the stock price increases For a given strike price, the value of a put option decreases as the stock price increases

Option Prices and the Exercise Date

For American options, the longer the time to the exercise date, the more valuable the option A European option with a later exercise date may potentially trade for less than an otherwise identical option with an earlier exercise date

Factors Affecting Option Prices

Option Prices and the Risk-Free Rate
The value of a call option increases as the risk-free rate increase The value of a put option decreases as the risk-free rate increase

Option Prices and Volatility

The value of an option increases as the volatility of the stock increases

How an Increase in Each Factor Affects Option Values

The Black-Scholes Option Pricing Formula

Black-Scholes Price of a Call Option on a NonDividend-Paying Stock
Call Price = Stock Price N(d1) PV(Strike Price) N(d2)

d1

ln[Stock Price/PV(Strike Price)] T 2 T

d 2 d1 T

Online Option Pricing Calculator

Put-Call Parity
Portfolio Insurance
Protective Put
Purchasing a put option on a stock you already own

Portfolio Insurance
A protective put written on a portfolio rather than a single stock

Portfolio Insurance

Put-Call Parity
Portfolio Insurance
Put-Call Parity: Non-Dividend-Paying Stock
Consider the two different ways to construct portfolio insurance illustrated in the example:
Purchase the stock and a put Purchase a bond and a call Because both positions provide exactly the same payoff, the Law of One Price, requires that they must have the same price: Stock Price + Put Price = PV(Strike Price) + Call Price

Put-Call Parity
Portfolio Insurance
Put-Call Parity: Non-Dividend-Paying Stock
Put-Call Parity
Stock Price + Put Price = PV(Strike Price) + Call Price Rearranging terms gives an expression for the price of a European call option for a non-dividend-paying stock: Call Price = Put Price + Stock Price PV(Strike Price)

Options and Corporate Finance

Option to delay, change, or abandon a project Option to call a bond early Stock can be thought of as a call option on the assets of the firm with a strike price equal to the value of debt outstanding

Equity as a Call Option