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Corporate Finance Basic Concepts

Corporate Finance Basic Concepts

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Chapter 22: Options and Corporate Finance: Basic Concepts
Chapter 22: Options and Corporate Finance: Basic Concepts

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Published by: Presidency Student Forum on Jul 30, 2010
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10/25/2012

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Chapter 22: Options and Corporate Finance:
 Basic Concepts
22.1
a.
An
option
is a contract giving its owner the right to buy or sell an asset at a fixed price on or beforea given date.
 b.
Exercise
is the act of buying or selling the underlying asset under the terms of the option contract.
c.
The
strike price
is the fixed price in the option contract at which the holder can buy or sell theunderlying asset. The strike price is also called the exercise price.
d.
The
expiration date
is the maturity date of the option. It is the last date on which an Americanoption can be exercised and the only date on which a European option can be exercised.
e.
A
call option
gives the owner the right to buy an asset at a fixed price during a particular time period.
f.
A
put option
gives the owner the right to sell an asset at a fixed price during a particular time period.22.2An American option can be exercised on any date up to and including the expiration date. A Europeanoption can only be exercised on the expiration date. Since an American option gives its owner the rightto exercise on any date up to and including the expiration date, it must be worth at least as much as aEuropean option, if not more.22.3The put is not correctly priced. An American put option must always be worth more than the value of immediate exercise. The value of immediate exercise for a put option equals the strike price minus thecurrent stock price. In this problem, the value of immediate exercise is $5 (= $40 - $35). Since the optionis currently selling for $4.50, less than the value of immediate exercise, the option is underpriced.Consider the following investment strategy designed to take advantage of the mispricing:StrategyCash Flow1. Buy put option-$4.502. Buy stock-$35.003. Exercise put option +$40.00Arbitrage Profit+$0.50Therefore, Mr. Nash should buy the option for $4.50, buy the stock for $35, and immediately exercise the put option to receive its strike price of $40. This strategy yields a riskless, arbitrage profit of $0.50 (=$5 -$4.50).22.4a. If the option is American, it can be exercised on any date up to and including its expiration onFebruary 25. b.If the option is European, it can only be exercised on its expiration date, February 25.c.The option is not worthless. There is a chance that the stock price of Futura Corporation will riseabove $45 sometime before the option’s expiration on February 25. In this case, a call option with astrike price of $45 would be valuable at expiration. The probability of such an event happening is built into the current price of the option.22.5a. The payoff to the owner of a call option at expiration is the maximum of zero and the current stoc price minus the strike price. The payoff to the owner of a call option on Stock A on December 21 is:max[0, S
T
- K] = max[0, 55-50] =
$5
whereS
T
= the price of the underlying asset at expirationK= the strike priceB-115
 
 b.The payoff to the seller of a call option at expiration is the minimum of zero and the strike priceminus the current stock price. The payoff to the seller of a call option on Stock A on December 21is:min[0, K- S
T
] = min[0, 50-55] =
-$5
In other words, the seller must
 pay
$5.c.The payoff to the owner of a call option at expiration is the maximum of zero and the current stock  price minus the strike price. The payoff to the owner of a call option on Stock A on December 21 is:max[0, S
T
- K] = max[0, 45-50] =
$0
d.The payoff to the seller of a call option at expiration is the minimum of zero and the strike priceminus the current stock price. The payoff to the seller of a call option on Stock A on December 21is:min[0, K- S
T
] = min[0, 50-45] =
$0
e.
051015202530 35 40 45 50 55 60 65 70
Stock Price at Expiration
   P  a  y  o   f   f   t  o   O  w  n  e
B-116
 
f.
-25-20-15-10-5030 35 40 45 50 55 60 65 70
Stock Price at Expiration
   P  a  y  o   f   f   t  o   S  e   l   l  e
g.The seller of a call option receives a premium, the price of the option, at the time of sale. Atexpiration, if the buyer chooses not to exercise, the premium becomes pure profit for the seller.Therefore, an individual will write (sell) a call option if he does not believe the stock price will riseabove the strike price before expiration.22.6a.The payoff to the owner of a put option at expiration is the maximum of zero and the strike priceminus the current stock price. The payoff to the owner of a put option on Stock A on December 21is:max[0, K- S
T
] = max[0, 50-55] =
$0
whereS
T
= the price of the underlying asset at expirationK= the strike price b.The payoff to the seller of a put option at expiration is the minimum of zero and the current stock  price minus the strike price. The payoff to the seller of a call option on Stock A on December 21 is:min[0, S
T
- K] = min[0, 55-50] =
$0
c.The payoff to the owner of a put option at expiration is the maximum of zero and the strike priceminus the current stock price. The payoff to the owner of a put option on Stock A on December 21is:max[0, K- S
T
] = max[0, 50-45] =
$5
d.The payoff to the seller of a put option at expiration is the minimum of zero and the current stock  price minus the strike price. The payoff to the seller of a call option on Stock A on December 21 is:min[0, S
T
- K] = min[0, 45-50] = -
$5
In other words, the seller must
 pay
$5.B-117

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