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Corporate Finance

Option
1. An option grant the buyer “Right” but “NOT Obligation”

-

to buy (call option) to sell (put option)

an underlying asset (shares, bonds, currencies, commodities) at a specific price (exercise price or strike price) on a specific date (European option) or anytime from now to the expiry date (American option)

2. What is “Right but NOT obligation” means? – Buying (Long) Position

Example 1: Long Call on eBay (European option)

Option price (premium) = $5 Strike (exercise) price = $100

Buyer pay option premium $5 to the Writer, hedge against stock price increase!

Buyer has the right to exercise the option when it is “in-the-money” (i.e. Stock price is > exercise price $100)

But if it is “out-of-money” (i.e. Stock price is < exercise price) The Buyer has no obligation to exercise the option, (i.e. buy stocks @ $100) therefore the option is lapsed.
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(<$100) Payoffs – Long Call position Profit +30 +20 +10 0 . hedge against stock price decrease! Buyer has the right to exercise the option when it is “in-the-money” JYHUN Page 2 . The Buyer will then buy stocks directly from the market @ market price.Corporate Finance The only cost to the buyer is the $5 premium paid when buying the option.10 70 80 90 100 --w-----I-----I-----I-----I-----I-----I-----I--Stock price 110 120 130 Example 2: Long Put on eBay (European option) Option price (premium) = $5 Strike (exercise) price = $100 Buyer pay option premium $5 to the Writer.

sell shares @ $100) therefore the option is lapsed.10 100 110 120 130 --w-----I-----I-----I-----I-----I-----I-----I--Stock price 70 80 90 JYHUN Page 3 . The only cost to the buyer is the $5 premium paid when buying the option. (>$100) Payoffs – Long Put position Profit +30 +20 +10 0 .e.e. The Buyer will then sell its stocks at market price.e. Stock price is > exercise price) The Buyer has no obligation to exercise the option (i. Stock price is < exercise price) But if it is “out-of-money” (i.Corporate Finance (i.

But if the stocks’ price is dropped < $100. he has to sell to Buyer @ $100. JYHUN Page 4 . Buyer will exercise the option when the stocks’ price increased > $100. Then the Writer will earn the $5 option premium.Corporate Finance 3. Selling (Short) Position Writer – the one who create and sell an option. (means buyer will buy stocks from Writer @ $100) If the Writer owned the stocks (Covered call). the option will be lapsed. But if the Writer did not owned the stocks (Naked Call). he has to buy from the market and then sell to Buyer @ $100. Example 3: Short Call on eBay (European option) Option price (premium) = $5 Strike (exercise) price = $100 Writer sell call option bet the stocks’ price will not increased.

Buyer will exercise the option when the stocks’ price dropped < $100.20 .10 . JYHUN Page 5 .Corporate Finance Payoffs – Short Call position Profit +10 0 .30 110 120 130 --w-----I-----I-----I-----I-----I-----I-----I--Stock price 70 80 90 100 Example 4: Short Put on eBay (European option) Option price (premium) = $5 Strike (exercise) price = $100 Writer sell put option bet the stocks’ price will increase.

Then the Writer will earn the $5 option premium. But if the stocks’ price is increased > $100.30 70 80 90 --w-----I-----I-----I-----I-----I-----I-----I--Stock price 100 110 120 130 4.Corporate Finance This means Buyer will sell stocks to Writer @ $100 and the Writer has to accept. the option will be lapsed. Summary .20 . Payoffs – Short Put position Profit +10 0 .Payoffs In the Money At the Money Out of Money Call Option E<S E=S E>S Put Option S<E S=E S>E E = Exercise price S = Stocks price JYHUN Page 6 .10 .

7 . Action Now: Buy the option for $3 Short the stock @ $20 The net cash flow ($20-$3)=$17 invest one year @ Risk free rate 10% End of Year 1: (if the Stock price > $18) Exercise the option to buy stock @ $18 in order to close out the short position (sell stock at beginning).70 End of Year 1: (if the Stock price < $18) Buy the stock in the market (Say for example $15) in order to close out the short position (sell stock at beginning).70 Therefore the benefit is -$3 + $20 -$18 + $1. Received investment return ($17 x 1. 0] Value of put option: p = max [E – S.10) = $1. American Option Value if it is “In-the-money” Value of call option: c = max [S – E.$X (say if the stock price is $15.a.70 = $3.70 = $18.70 = $0.70) JYHUN Page 7 . An Arbitrage Opportunity? Example: European Call Option Option premium = $3 Option life = 1 year Strike price = $18 Current stocks price = $20 Risk-free rate = 10% p. Received investment return ($17 x 1. it will be = -$3 + $20 -$15 + $1. 0] 6.Corporate Finance 5.70 Therefore the benefit is -$3 + $20 -$X + $1.10) = $1.

Strategies Involving A single Option and A Stock [a] Long Stock + Long Put = Long Call (protective put) Profit Long Stock Long Call I E Stock price Long Put [b] Long Stock + Short Call = Short Put (Covered call) Profit Long Stock I E Short Put Stock price Short Call JYHUN Page 8 .Corporate Finance 7.

Corporate Finance [c] Short Stock + Long Call = Long Put Profit Long Call E I Stock price Long Put Short Stocks [d] Short Stock + Short Put = Short Call Profit I E Short Put Stock price Short Call Short Stock JYHUN Page 9 .

5% Exercise price = $40 Call premium = $4 Put premium = $3 Option life = 3 months S = PV(E) + C – P S = [$40 / (1.005)3] + $4 .$3 = $40. the present value of Exercise price is discounted @ Risk-free rate! Example: Risk-free rate = 0.Corporate Finance 8. S + P = PV(E) + C ⇒ S = PV(E) + C .P Note. Put Call parity Value of Put + Share price = Value of Call + Present Value of Exercise price Therefore.41 JYHUN Page 10 .