OPTIONS

Chapter 8
 WHAT COMPANIES DO
Increasing your (investment) options
CitiFirst, part of the CitiGroup in Australia, promotes ‘CitiFirst
Warrants’ for investors. The statement lists some potential benefits for
investors who buy and hold CitiFirst Warrants:
• being exposed to the price movements of the underlying asset
• having the ability to buy and sell the CitiFirst Warrants on the ASX
at
any time prior to the date when the warrants expire
• being able to capture greater returns per dollar of investment than if
the investor bought and held the underlying asset itself
• having the ability to fix the price at which the underlying asset such
as shares could be bought
• being able to take advantage of both rising and falling markets.
Source: CitiFirst Trading Warrants, Product Disclosure Statement, Equity Call and Put Warrants, 2 November 2012. Issued by
Citigroup Global Markets Australia Pty Limited, http://www.citifi rst.com.au/content/library/pds/20121102_PDS_Single%20Stock%20Trading
%20Warrant.pdf (accessed 1 January 2013).
 FINANCE IN PRACTICE
CFO survey evidence: options, compensation and hedging practices
 ECONOMIC BENEFITS
PROVIDED BY OPTIONS
Derivative securities are instruments that derive their value
from the value of other assets.

Derivatives include options, futures and swaps.

Options and other derivative securities have several important economic

functions:

• Help bring about more efficient allocation of risk.

• Save transactions costs … sometimes it is cheaper to trade a derivative
than its underlying asset.
• Permit investment strategies that would not otherwise be possible.
 OPTIONS VOCABULARY
• Gives the holder the right to purchase an
Call option asset at a specified price on or before a
certain date.
• Gives the holder the right to sell an asset at a
Put option specified price on or before a certain date.

• The date on which the right to buy or sell the

Expiration date underlying asset expires.

Strike price or exercise price: the price specified for purchase

or sale in an option contract
American or • American options allow holders to exercise
at any point prior to expiration.
European • European options allow holders to exercise
option only on the expiration date.
 OPTIONS VOCABULARY
• The buyer of an option has a long
Long position position, and has the ability to exercise
the option.
• The seller (or writer) of an option has a
short position, and must fulfill the
Short position contract if the buyer exercises.
• As compensation, the seller receives the
option premium.

Let S = current share price and X = strike price

Call Put
S>X In the money Out of the money
S=X At the money At the money
S<X Out of the money In the money
 OPTIONS VOCABULARY
Options trade on an exchange (e.g., the ASX – Australian
Securities Exchange – or Chi-X Australia) or in the over-the-
counter market.

Counterparty • The risk that the counterparty in an over-

the-counter options transaction will default
risk on its obligation.

• One party pays the other the cash value of

Cash settlement the option position, rather than actually
buying or selling the underlying asset.
 FINANCE IN THE REAL WORLD

‘We’re in the money’

The table to the right illustrates
how the payoff on your options
depends on the company’s
share price, assuming that you
plan to exercise them as soon
as they vest if they are in the
money.
 INTRINSIC AND TIME
VALUE OF OPTIONS
• For in-the-money options: the difference
between the current price of the underlying
Intrinsic value asset and the strike price
• For out-of-the money options: the intrinsic
value is zero

Out of the • A call (put) option is out of the money when

the share price is less (greater) than the
money strike price

• The difference between the option’s intrinsic

Time value value and its market price (premium)
 OPTION PAYOFF DIAGRAMS
Show how the value of an option varies as the underlying
asset price changes.

Y-axis plots exercise value, or ‘intrinsic value’

X-axis plots price of underlying asset

Long and short positions

Use payoff diagrams
for: Gross and net positions (the net positions subtract
the option premium)

Payoff: the price of the option at expiration date

 NAKED OPTION POSITIONS
• Naked call option position – occurs when
an investor buys or sells an option on a
share without already owning the
underlying share.
• Naked put option position – occurs when
a trader buys or sells a put option without
owning the underlying share.
 PORTFOLIOS OF OPTIONS
Look at payoff diagrams for combinations of options rather than
just one.

Diagrams show the range of potential strategies made possible

by options.

Some positions, in combination with other positions, can be a

form of portfolio insurance.
 STRADDLE POSITIONS
• Long straddle – a portfolio consisting of
long positions in calls and puts on the
same share with the same strike price
and expiration date.
• Short straddle – a portfolio consisting of
short positions in calls and puts on the
same share with the same strike price
and expiration date.
 PUT–CALL PARITY
• A relationship that links the market prices of
Put–call parity shares, risk-free bonds, call options and put
options.

Payoff Payoff Payoff Payoff

on bond + on call = on share + on put

• To prevent arbitrage opportunities, the price of a portfolio

consisting of a bond and a call option must equal the
price of a portfolio consisting of one share and one put
option.
Current Current Current price of Current
share + price of = risk-free, zero- + price of call
price put option coupon bond option
 FACTORS THAT INFLUENCE
OPTION VALUES
Price of • Asset price and call price are positively
underlying related.
• Asset price and put price are negatively
asset
related.

Time to • More time usually makes options more

expiration valuable.

• Higher X means higher put price; lower X

Strike price
means higher call price.

• Calls: higher r means higher call value

Interest rate
• Puts: higher r reduces put value
QUALITATIVE ANALYSIS OF
OPTION PRICES
QUALITATIVE ANALYSIS OF
OPTION PRICES
QUALITATIVE ANALYSIS OF
OPTION PRICES
 FACTORS THAT INFLUENCE
OPTION VALUES
• Holding other factors constant, call and put
option prices increase as the time to expiration
increases.
• Call prices increase and put prices decrease
when the difference between the underlying
stock price and the exercise price (S − X)
increases.
• Call and put option prices increase as the
volatility of the underlying stock increases.
 OPTION PRICING MODELS
• The binomial model recognises that investors
can combine options (either calls or puts) with
shares of the underlying asset to construct a
portfolio with a risk-free payoff.
• The value of the risk-free portfolio can be
computed by discounting its future cash flows at
the risk-free rate.
• The value of the options can then be derived by
subtracting the value of the shares from the
value of the portfolio.
 THE BINOMIAL MODEL
Step 1
Create a
risk-free
portfolio
 THE BINOMIAL MODEL
Step 2 Calculate the present value of the portfolio

$40
Risk-free rate = 4%, so present value of the portfolio = 1.04 = $38.46
 THE BINOMIAL MODEL

Step 3 Determine the price of the option

One share of share costs $55, so:

total portfolio cost = $55 – 2C = $38.46
Solving for C gives a call value of $8.27
THE BLACK AND SCHOLES MODEL
The reasoning behind the Black and Scholes model is similar
to that behind the binomial model:

Does a combination of option and shares exist that provides a

risk-free payoff?

• Share prices can move at every moment in

time.
• Movements of share prices are random and
Assumptions of therefore unpredictable.
the model • Volatility (standard deviation) of share
movements is known.
THE BLACK AND SCHOLES MODEL
C  SN d1   Xe  rt N d 2 
2
S    
ln     r  t
X   2 
where d1 
 t
d 2  d1   t
• S = current market price of underlying share
• X = strike price of option
• t = amount of time before option expires (in years)
• r = annual risk-free interest rate
•  = annual standard deviation of underlying share’s returns
• e = 2.718 (approximately)
• N(X) = probability of drawing a value less than or equal to X from the standard
normal distribution
 AN EXAMPLE
• The price of Cloverdale Food Processors is currently $40.
− A European call option on Cloverdale has an expiration date six
months in the future and a strike price of $38.
− An estimate of standard deviation on Cloverdale is 45% and the
risk-free rate is 6%.

What should the call price be?

 40   0.452  1
ln     0.06  
 38   2 2
d1   0.4146
0.45 1 / 2
d 2  d1   t  0.0964

N(0.4146) = 0.6608 N(0.0964) = 0.5384

C = 40(0.6608) – 38(2.718-(.06)(0.5))(0.5384) = $6.58
OPTIONS IN CORPORATE FINANCE
• Many companies use employee share option
Employee grants (ESOs) as part of their compensation
packages.
share options • ESOs are essentially call options that give
employees the right to buy shares in the
company they work for, at a fixed price.
• Securities that grant rights similar to a call
option, except that when a warrant is
Warrants exercised, the company must issue a new
share and it receives the strike price as a cash
inflow.
• A convertible bond gives investors the right
Convertibles to convert their bonds into shares.