CORPORATE FINANCE – II

Sessions 3 and 4
Options
N I T IN KU M A R
I N DI A N S CHOOL OF BU S I N ESS
T E R M- 4
Learning Goals
• Why do we need to understand options?
• Option basics
• Option payoffs
• Option moneyness
• Put-call parity
• Factor that affect option prices
Why do you need to know about the
options?
• Suppose you are working as a consultant. Your Indian client comes to you for advice for managing the uncertain
future cash flows from foreign operation.
• Your client started operations around 2018 for a US based company and will start receiving dollar receipts from 2021.
• Your client also wants to use uncertain future cash flows for another domestic project.
• The problem is uncertain future receipts.
• Solution?
Why do you need to know about the
options?
• You have invested large sum in the stock market, hoping that the market will go up.
• But you are worried about the future uncertainty because of change in govt and new policies that will impact
manufacturing and tech sector.
• How can you manage investment risk?
Options - Agenda
1.Basics

2.Holder and Writer

3.Long Call Payoff

4.Short Call Payoff

5.Net Position in a Call Option Contract

6.Long Put Payoff

7.Short Put Payoff

8.Net Position in a Put Option Contract

9.Summary of Payoff Formulas

10.Option Moneyness

11.Option Premium

12.Option Combinations

13.Put-Call parity

14.Factor affecting option prices

7
1. Basics
• Option gives you the right to buy/sell an asset at a specified price at some future date.
• NOTE: There is no obligation for the option buyer. More on this in a while...

• Two types of options:

• A Call option is the right, but not the obligation, to buy an asset for a certain price at some
future date.

• A Put option is the right, but not the obligation, to sell an asset for a certain price at some
future date.

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 Underlying

1. Basics
• Option gives you the right to buy/sell an asset at specified future time
at a specified price.

Maturity Date=T
Strike Price=K

9
1. Basics
• Option gives you the right to buy/sell an asset at specified
future time at a specified price.

European: On the maturity date

Maturity Date

American: On or before the maturity

date

10
2. Holder and Writer
•Every contract has two parties
• Buyer
• Seller
•Same applies to the option contract
•Two sides to any option position
• Buyer of the contract buys the right to exercise the option and pays the price. Price is
also called premium.
• Seller of the contract sells the right to exercise the option and receives the premium
• What is being transacted?
• The right to exercise the contract. That contract is the option.

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2. Holder and Writer
• In a call option contract, there are two parties
• Call option purchaser or the long-party
• Call option seller or writer or the short-party
• Similarly, in a put option contract, there are two parties
• Put option purchaser or the long-party
• Put option seller or writer or the short-party
• In both call and put option contracts
• Purchaser or the long-party has the right
• Seller or the short-party has the obligation

12
3. Long Call Payoff
•Let’s say that you purchased a call option on the IBM stock
• Current trading price on Nov 30 = $77.5

• Buy a call:
• Strike price, K = $80; Expiration date, T = Dec 31

• If Price on Dec 31, S = $85, what will you do with your option? And what will be your payoff?
• Exercise the option, How?
• Purchase the stock from the seller of the option for $80 (at strike price K), and sell in the market for $85 (at
price S)
• Payoff = $85 - $80 = S-K = $5

• If price on Dec 31, S = $75, what will you do with your option?
• Not exercise the option, your option expires
• Payoff = 0

13
3. Long Call Payoff
• Long Position in a Call Option Contract
• The value of a call option at expiration is
• C = max(S-K, 0)
• Where, S is the stock price at expiration
• K is the exercise price
• C is the value of the call option for the holder
• max is the maximum of the two quantities in the parentheses

14
3. Long Call Payoff
Long Call on IBM
with Strike Price (K) = $80

80

60

40
Payoff

20

0
0 20 40 60 K =80 100 120 140 160
-20
IBM Terminal Stock Price

15
4. Short Call Payoff
• What if you had the short position?
• After you enter into the contract, you have granted the option to the long-
party.
• If the long-party wants to exercise the option, you have to do what?
• Sell the stock to the long party at the strike price, because you are obligated to do
so.

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4. Short Call Payoff
• Of course, the long-party will only exercise the option when it is in its best interest to do so – that is,
when the stock price is greater than the strike price.
• So if the stock price is less than the strike price (S<K), then the long party can just buy the stock in the
market, and so the option will expire, and you, as the short party, are not required to do anything.
• Your payoff = 0
• If the stock price is more than the strike price (S>K), however, then the long party will exercise their
option and you will have to purchase the asset for S (if you don’t own it) and sell to the long party for
K.
• Your payoff = –S(from buying from the market) + K(from selling to the long-party) = K-S

17
4. Short Call Payoff
•Let’s say that you sold a call option on IBM stock:
• Current trading price at Nov 30 = $77.5

• Sell/Write a call:
• Strike price, K = $80, Expiration date, = Dec 31

• If Price on Dec 31, S = $85, what can you expect?

• The long-party will exercise its option, and you have to purchase the stock from the market at $85 (at
price S), and sell it to the long-party for $80 (at price K).
• Your payoff = -S + K = K-S
• In this case, payoff = -5

• If price on Dec 31, S = $75, what can you expect?

• The holder of the option, i.e. the long party, will not exercise the option.
• Your payoff = 0

18
 4. Short Call Payoff
• Short Position in a Call Option Contract
• The value of a call option at expiration is
• C = min(0, K-S) = -max(S-K, 0)
• Where, S is the stock price at expiration
• K is the exercise price
• C is the value of the call option for the holder
• max (min) is the maximum (minimum) of the two quantities in the parentheses

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4. Short Call Payoff
Short Call Position on IBM Stock
with Strike Price (K) = $80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price

20
4. Short Call Payoff
•This is obviously the mirror image of the long position payoff.
•Notice, however, that at maturity, the short option position can NEVER have a positive
payout – the best that can happen is that they get $0.
• What is its implication?

• Short option party always demands an up-front payment – it’s the only payment they
are going to receive. This payment is called the option premium or price.
•Once again, the two positions “net out” to zero.

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5. Net Position in a Call Option Contract
Long and Short Call Options on IBM
with Strike Prices of $80

100
80
60 Long Call
40
20 Net Position
Payoff

0
-20 0 20 40 60 80 100 120 140 160

-40
-60 Short Call
-80
-100
Ending Stock Price

22
Put Options
•So far…
• We learned about the call option payoff for
• Buyer
• Seller

• Let’s do the same for put option

23
6. Long Put Payoff
•Let’s say that you purchased a put option on the IBM stock
• Current trading price at Nov 30 = $77.5

• Buy a put:
• Strike price, K = $80; Expiration date, T = Dec 31

• If price on Dec 31, S = $75, what will you do with your option?
• Exercise the option. How?
• Buy at market price = $75, and sell it to the writer of the put option for $80
• Payoff = $80 - $75 = K-S = $5

• If Price on Dec 31, S = $85, what will you do with your option? And what will be your payoff?
• Not exercise the option
• Payoff = 0

24
6. Long Put Payoff
Long Position in a Put Option Contract
◦ The value of a put option at expiration is
◦ C = max(K-S, 0)
◦ Where, S is the stock price at expiration
◦ K is the exercise price
◦ C is the value of the call option for the holder
◦ max is the maximum of the two quantities in the parentheses

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6. Long Put Payoff
Payoff to Long Put Option on IBM
with Strike Price of $80

80
70
60
50
Payoff

40
30
20
10
0
-10 0 20 40 60 80 100 120 140 160

Ending Stock Price

26
7. Short Put Payoff
•Let’s say that you sold a put option on IBM stock:
• Current trading price at Nov 30 = $77.5
• Sell/Write a put:
• Strike price, K = $80, Expiration date, = Dec 31

• If Price on Dec 31, S = $85, what can you expect?

• The long-party will exercise not exercise the option.
• Your payoff = 0

• If price on Dec 31, S = $75, what can you expect?

• The holder of the option, i.e. the long-party, will exercise the put option, and you have to purchase the stock from
the long-party for $80 (at strike price K) and sell it in the market for $75 (at market price S)
• Your payoff = -K (from buying the stock from the long-party) + S (from selling the stock at the market price) = S-K =
-$5

27
7. Short Put Payoff
• Short Position in an Put Option Contract
• The value of a put option at expiration is
• C = Min(0, S-K) = -max(K-S, 0)
• Where, S is the stock price at expiration
• K is the exercise price
• C is the value of the call option for the holder
• max (min) is the maximum (minimum) of the two quantities in the parentheses

28
7. Short Put Payoff
Short Put Option on IBM
with Strike Price of $80

0
0 20 40 60 80 100 120 140 160

-21.25
Payoff

-42.5

-63.75

-85
Ending Stock Price

29
7. Short Put Payoff
•Since the short put party can never receive a positive payout at maturity, they demand a
payment up-front from the long party – that is, they demand that the long party pay a
premium to induce them to enter into the contract.

•Once again, the short and long positions net out to zero: when one party wins, the other
loses.

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8. Net Position in a Put Option Contract
Long and Short Put Options on IBM
with Strike Prices of $80

100 Long Position

80
60 Net Position
40
20
Payoff

0
-20 0 20 40 60 80 100 120 140 160
-40 Short Position
-60
-80
-100
Ending Stock Price

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9. Summary of Payoff Formulas
•For a European call, the payoff to the option is:
• Max(0,S-K)

•For a European put it is

• Max(0,K-S)

•The short positions are just the negative of these:

• Short call: Min(0,K-S) = -Max(0,S-K)
• Short put: Min(0,S-K) = -Max(0,K-S)

32
10. Option Moneyness
•Traders frequently refer to an option as being “in the money”, “out of the money” or “at the
money”.
• An “in the money” option means one where the price of the underlying stock is such that if
the option were exercised immediately, the option holder would receive a payout.

• For a call option this means that St>K

• For a put option this means that St<K

• An “at the money” option means one where the strike and exercise prices are the same,
St=K

33
10. Option Moneyness
• An “out of the money” option means one where the price of the underlying stock is such that if the
option were exercised immediately, the option holder would NOT receive a payout.

• For a call option this means that St<K

• For a put option this means that St>K.

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10. Option Moneyness
•Call Option
• In the money: St>K

• Out of the money: St<K

• At the money: St=K

•Put Option
• In the money: St<K

• At the money: St=K

• Out of the money: St>K

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10. Option Moneyness for Long Call
Long Call on IBM
with Strike Price (K) = $80

80

60

At the money
40
Payoff

Out of the money In the money

20

0
0 20 40 60 K = 80 100 120 140 160
-20
IBM Terminal Stock Price
T

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11. Option Premium
• Option premium = option price = price demanded by the option seller
• The standard options contract is for 100 units of the underlying asset and price is quoted
per stock.
• Thus, if the option is selling for $5 on a stock, you would have to enter into a contract for
100 of the underlying stock, and thus the cost of entering would be 100 x $5 = $500 for 1
option contract.
• This is the premium or the price of the option contract, which the buyer of the
option pays to the seller.

37
11. Option Premium Effect on Payoff (Long Call)

38
11. Option Premium Effect on Payoff (All 4
Options)

39
12. Option Combinations
•You can hold a portfolio of options (just like you can hold a portfolio of stocks).

•Payoffs will then depend on the payoffs of underlying options in your portfolio

•You can combine calls, puts, stocks, risk-free bonds

•Let’s examine some of the most popular option combinations…

40
12. Option Combinations - Protective Put
• When you buy a stock, what are you betting on?
• you are betting that its price will rise.
• But what if your assessment is wrong, and price plummets?
• You can guard your downside, by buying a put option on the same stock.
• That is, you are
• Long on the stock
• Long on the put on the same stock

41
12. Option Combinations - Protective Put
(Example)
• For each 100 shares of the stock you own, buy one put option contract.
• Say you own a stock with current price = $50, buy a $45 put.
• If the stock goes down to $40
• You can exercise your put and sell it for $45
• Your downside is protected.

42
12. Option Combinations - Protective Put
(Example)

43
12. Option Combinations - Protective Put
• You can follow the same strategy for your full portfolio of stocks
• Portfolio Insurance
• A protective put written on a portfolio rather than a single stock.

44
13. Put-Call Parity
• You can also achieve the same insurance by
• Buying a bond
• Purchase a risk-free zero-coupon bond with a face value of $45
• And also buying a call option
• Call option with a strike price (K) = $45
• If at time T, expiration date, stock price < $45
• Payoff from bond = $45
• Payoff from call = $0
• If at time T, expiration date, stock price >= 45
• Payoff from bond = $45
• Exercise call option to buy the stock at $45
• How does the payoff look like?

45
13. Put-Call Parity

46
13. Put-Call Parity
(Compare the two payoffs side-by-side)

47
 13. Put-Call Parity
•Because both positions provide exactly the same payoff, the Law of One Price (or no arbitrage) requires
that they must have the same price at any time t before maturity
•Therefore, Price(stock) + Price(Put) = Price(Risk-less Bond) + Price(Call Option)

• St is the stock price at time t

• Pt is the put price at time t
• Ct is the call price at time t
• K is the strike price of the option (the price you want to ensure that the stock will not drop below)
•Rearranging the terms gives an expression for the price of a European call option for a non-dividend-
paying stock.
•This relationship between the value of the stock, the bond, and call and put options is known as put-call
parity.

48
14. Factors Affecting Option Premium – Strike Price
•Call option
• Higher the strike price (K)
• => lower the profit for the call option buyer.
• => lower the loss for the call option writer.
• => lower the price demanded (or premium) by option writer from buyer.
•Put option
• Higher the strike price (K)
• => higher the profit for the put option buyer.
• => higher the loss for the put option writer.
• => higher the price demanded (or premium) by option writer from buyer.

49
14. Factors Affecting Option Premium – Type of Option
• If all else is same, an American option can/cannot? be worth less than the European
option.

50
15. Other Factors and Option Premium
Input Call Option Put Option
Price Price

Stock Price (St) ↑ ↑ ↓

Strike Price (K) ↑ ↓ ↑

Volatility (σ ) ↑ ↑ ↑
Why do you need to know about the
options?
• Suppose you are working as a consultant. Your Indian client comes to you for advice for managing the uncertain
future cash flows from foreign operation.
• Your client started operations around 2018 for a US based company and will start receiving dollar receipts from 2021.
• Your client also wants to use uncertain future cash flows for another domestic project.
• The problem is uncertain future receipts.
• Solution?
Why do you need to know about the
options?
• You have invested large sum in the stock market, hoping that the market will go up.
• But you are worried about the future uncertainty because of change in govt and new policies that will impact
manufacturing and tech sector.
• How can you manage investment risk?

• Solution: Buy put option on your manufacturing and tech stocks.

Learning Goals - Check
• Why do we need to understand options? ✓
• Option basics ✓
• Option payoffs ✓
• Option moneyness ✓
• Put-call parity ✓
• Factor that affect option prices ✓
Mapping to the text
• 20.1, 20.2, 20.3, 20.4

55
Bird’s Eye View of What We Did
Valuation of securities

Debt
Risk-free Bond Valuation:
Equity Valuation:
1. YTM
1. Discounted cash flow
2. Zero coupon yield curve
2. Valuation multiples Equity 3. Pricing of coupon bonds
4. Duration

Options:
1. Option payoffs
2. Put call parity
3. Factors that impact option prices

56
Learning Goals - Check
• Bonds
• Why do we need to understand
bonds? ✓
• What are bonds? ✓
• Bond terminology ✓
• What are zero coupon bonds? ✓
• What is Yield to Maturity? ✓
• What are coupon bonds? ✓
• Pricing of coupon bonds ✓
• Interest rate risk ✓
• Equity Valuation
•Why equity valuation is
important? ✓
• What are the different methods
of equity valuation? ✓
• What are the limitations of the
methods of equity valuation? ✓
• Why we should exercise caution in
applying these methods? ✓
• What is Efficient Market
Hypothesis? ✓
• How “market prices” and
“underlying information” are
linked? ✓
• Options
• Why do we need to
understand options? ✓
• Option basics ✓
• Option payoffs ✓
• Option moneyness ✓
• Put-call parity ✓
• Factor that affect option
prices ✓

57
Good luck for your exams and placements!