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Fundamentals of Corporate Finance: by Robert Parrino, Ph.D. & David S. Kidwell, PH.D
Fundamentals of Corporate Finance: by Robert Parrino, Ph.D. & David S. Kidwell, PH.D
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CHAPTER 20
Quick Links
Financial Options Call Options Put Options American, European, and Bermudan Options More on the Shapes of Option Payoff Functions Option Valuation Limits On Option Valuation Variables That Affect Option Values The Binomial Pricing Model Put-Call Parity Real Options Options to Defer Investment Options to Make Follow-On Investments Options to Change Operations Options to Abandon Projects
Chapter 20 Options and Corporate Finance
Concluding Comments on NPV Analysis and Real Options Agency Costs Agency Costs of Debt Agency costs of Equity Options and Risk Management
Financial Options
A financial option is a derivative security in that its
but not the obligation, to buy or sell an asset on or before a specified date for a specified price.
The asset that the owner has a right to buy or
Financial Options
The last date on which an option can be
exercised is called the exercise date or expiration date, and the price at which the option holder can buy or sell the asset is called the exercise price or strike price.
Call Options
A call option gives the owner the right to buy, or
price, the value of the call option at exercise increases dollar for dollar with the price of the underlying asset. The buyer pays the seller a fee to purchase the option.
Call Options
This fee, which is known as the call premium,
makes the total return to the seller positive when the price of the underlying asset is near or below the exercise price.
Put Options
The owner of a put option has the right to sell
is similar to that for a call option, but it is the reverse in the sense that the owner of a put option profits if the price of the underlying asset is below the exercise price. The owner of a put option will not want to exercise that option if the price of the underlying asset is above the exercise price.
Chapter 20 Options and Corporate Finance
Put Options
When the value of the underlying asset is below
the exercise price, however, the owner of the put option will find it profitable to exercise the option. The payoff for the seller of the put option is negative when the price of the underlying asset is below the exercise price.
The seller of a put option hopes to profit from the
fee, or put premium, that he or she receives from the buyer of the put option.
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price which exists because the owner of the option has a right, but not the obligation, to buy or sell the underlying asset. If it is not in the owners interest to exercise the option, he or she can simply let it expire.
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Option Valuation
It is more complicated to determine the value of
an option at a point in time before the expiration date because we dont know exactly how the value of the underlying asset will change over time, and therefore we dont know if it will make sense to exercise the option.
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never be less than zero, since the owner of the option can always decide not to exercise it if doing so is not beneficial. The value of a call option can never be greater than the value of the underlying asset since it would not make sense to pay more for the right to buy an asset than you would pay for the asset itself.
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never be less than the value of that option at expiration because there is always a possibility that the value of the underlying asset will be greater than it is today at some time before the option expires.
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some time prior to expiration, we must compare the current value of the underlying asset with the present value of the exercise price, discounted at the risk-free rate. The present value of the exercise price is the amount an investor would have to invest in riskfree securities at any point prior to the expiration date to ensure that he or she would have enough money to exercise the option when it expired.
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asset, the more likely it is that the value of the asset will be above the exercise price when the call option expires. The higher the current value of the asset, the greater the likely difference between the value of the asset and the exercise price when the option expires.
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constant, investors will pay more for a call option if the underlying asset value is higher, because the expected value of the option at expiration is higher. The opposite relation applies to the exercise price in that the lower the exercise price, the more likely that the value of the underlying asset will be higher than the exercise price when the option expires.
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value, the higher the value of a call option on the asset prior to valuation.
The intuition here is that the value of an option
will increase more when the value of the underlying asset goes up than it will decrease when the value of the underlying asset goes down; this means that a greater potential change in the underlying price will be more beneficial to the value of the option.
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value of the underlying asset is likely to change by the time the option expires; this increases the value of an option. The time until the expiration affects the value of a call option through its effect on the volatility of the value of the underlying asset.
The value of a call option increases with the risk-
free rate.
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the future for the underlying asset. The higher the interest rate, the lower the present value of the amount that the owner of a call option will have to pay to exercise it, which translates into value for the owner of the option.
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asset will have one of only two possible values when the option expires.
The value of the underlying asset will either
increase to some value above the exercise price or decrease to some value below the exercise price.
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model, we must assume that investors have no arbitrage opportunities with regard to this option.
Arbitrage is the act of buying and selling assets in
a way that yields a return above that suggested by the Security Market Line (SML).
To value the call option in our simple model, we
will first create a portfolio that consists of the asset underlying the call option and a risk-free loan.
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be selected so that the combination of the asset and the loan have the same cash flows as the call option when it expires, regardless of whether the value of the underlying asset goes up or down.
This is called a replicating portfolio, since it
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The value of the call option can be calculated as follows: Solve for the values of x and y. Multiply the current cost of the underlying stock by x. Subtracting y from the above amount will yield the value of the call option.
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Put-Call Parity
Although there are other methods, the value of a
put option can be calculated by the relationship of a put to a call option with the same maturity and exercise price. This relation is called put-call parity.
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Put-Call Parity
The formula for put-call parity is
P C Xert V
(20.1)
where: P is the value of the put option C is the value of the call option X is the exercise price V is the current value of the underlying asset e is the exponential function
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Put-Call Parity
Put-call parity example:
What is the value of ABC corporation put option if C=$5.95, X=$55, r=0.05, t=1, and V=$50? P = $5.95 + $55e-(0.05)(1) - $50 = $5.95 + $52.32 - $50 = $8.27
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Real Options
Real options are options on real assets. NPV analysis does not adequately reflect the value
of real options, and while it might not always be possible to directly estimate the value of the real options associated with a project, it is important to recognize that they exist when we perform a project analysis.
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government and an oil field development project. The Russian government waited to see what happened to the price of oil before deciding to exercise its option to acquire an ownership interest in the Sakhalin II project.
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of cash flows that the developed oil field would produce, while the exercise price is the amount of money that the company would have to spend to develop it (drill the well and build any necessary infrastructure).
The value of an option to defer investment is not
reflected in a NPV analysis as NPV analysis does not allow for the possibility of deferring an investment decision.
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opportunities that would not otherwise be available. This type of real option is an option to make follow-on investments. Options to make follow-on investments are inherently difficult to value because, at the time we are evaluating the original project, it may not be obvious what the follow-on projects will be.
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are consistent with a companys overall strategy are more valuable than otherwise similar projects that do not.
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flexibility that managers have once an investment decision has been made. These include the option to change operations and to abandon a project; they affect the NPV of a project and must be taken into account at the time the investment decision is made.
The changes that managers might make can
involve something as simple as reducing output if prices decline or increasing output if prices increase.
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otherwise be lost if the project kept going. The amount saved represents the gain from exercising this option.
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to expand operations, we would not only have to estimate all the cash flows associated with the expansion but would also have to estimate the probability that we would actually undertake the expansion and determine the appropriate rate at which to discount the value of the expansion back to the present.
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Agency Costs
Agency conflicts between stockholders and debt
holders and between stockholders and managers arise because the interests of stockholders, lenders (creditors), and managers are not perfectly aligned. One reason is that the claims that they have against the cash flows produced by the firm have payoff functions that look like different types of options.
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exactly like that of the owner of a call option, where the exercise price is the amount owed on the loan and the underlying asset is the firm itself.
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the stockholders will choose to exercise their option; and if it does not exceed the exercise price, they will let their option expire unexercised. One way to think about the payoff function for the lenders is that when they lend money to the firm, they are essentially selling a put option to the stockholders.
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put the assets to the lenders for an exercise price that equals the amount they owe.
When the value of the firm is less than the
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bankrupt, the stockholders might decide that they are better off taking money out of the firm by paying themselves dividends.
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receive all of the benefits if things turn out well but do not bear all of the costs if things turn out poorly.
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of the stockholders but managers do not always act in the stockholders best interest.
The payoff function for a manager can be quite
different from that for stockholders. In fact, it can look a lot like that of a lender.
If a company gets into financial difficulty and a
manager is viewed as responsible, that manager could lose his or her job and find it difficult to obtain a similar job at another company.
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defaulting on its debt, a manager has a reasonable chance of retaining his or her job.
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resembles that of a lender means that managers, like lenders, have incentives to invest in less risky assets and to distribute less value through dividends and stock repurchases than the stockholders would like them to.
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such as forwards, futures, and swaps, are commonly used to reduce risks associated with commodity prices, interest rates, foreign exchange rates, and equity prices. One interesting benefit of using options in this way is that they provide downside protection but do not limit the upside.
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way is that they provide downside protection but do not limit the upside.
This is just like buying insurance. Many insurance contracts are really little
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used to manage commodity price risks, large swings in interest rates, risks associated with foreign exchange rates, as well as to manage risks associated with equity prices as occurs within defined benefit pension plans.
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