Foundations of Finance (BMAN23000)

Foundations of Finance
(BMAN23000)
Dr. Stefan Petry

Alliance Manchester Business School
Accounting & Finance Group
Semester 2, 2021/22
Course structure
Week: Week:
1 Capital budgeting and risk Payout policy

5
2 Options and option valuation 6 Real options
3 Capital structure I 7 Equity and debt financing
4 Capital structure II 10
8 Revision
Stefan Petry BMAN23000 Semester 2, 2021/22 2 / 55

LECTURE 2
Options and option valuation

Readings for today
Option valuation:
• Berk, DeMarzo: Ch 20, 21.
• Bodie, Kane, Marcus: Ch. 20, 21.
• Brealy, Myers, Allen: Chapters 20 & 21.

Goal of today’s lecture
After the lecture, you will be able to:

• Understand the features of call and put options.
• Differentiate American and European-style options.
• Identify the factors that impact the value of an option.
• Value options via the Binomial Pricing Model.
• Understand key features of the Black-Scholes model.

Teaser
Derivatives derive value from prices of other assets
• Derivatives are securities that derive their value from

the price of other assets (called underlying).
• Most prevalent used derivatives are:
 Options
 Futures
 Forwards
• Can be powerful tools for hedging and speculation.
In this course, focus on options and their valuation.

Table of Contents
1. Option basics
2. Option payoff at expiration
3. Put-call parity
4. Option price determinants
5. Binomial option pricing
6. Black-Scholes option pricing model

1. Option basics
Options give right but not obligation to deal with asset
• Options
 trade both on organized exchanges and OTC.
 two types exist:
Call option Put option

• Gives its holder right but not the • Gives its holder right but not the
obligation to buy an asset: obligation to sell an asset:
 At the exercise or strike price  At the exercise or strike price
 On or before expiration date  On or before expiration date
• Exercise option to buy the • Exercise option to sell the
underlying asset if market value underlying asset if market value
of asset > strike price. of asset < strike price.
• Payoff = Max [0, ST – K] • Payoff = Max [0, K – ST ]

1. Option basics
Important options terminology to remember
Term Definition
Option premium Purchase price of the option.
Exercise/strike price (K) Price at which you buy or sell the security.
In-the-money option Exercise of option produces positive cash flow

 Call: exercise price < asset price: (K<ST)
 Put: exercise price > asset price: (K>ST)
At-the-money option Exercise price and asset price are equal (ST=K)
Out-of-the-money Exercise of the option would not be profitable
option  Call: asset price < exercise price: (ST<K)
 Put: asset price > exercise price: (ST>K)
Expiration Date Last date on which the option can be exercised.
American option Can be exercised at any time before expiration or maturity
(most options in U.S. except currency and stock index options).
European option Can only be exercised on expiration date.
1. Option basics
Option agreement consists of long and short side
• Two sides to Exchange Traded Option Agreement

 Option Purchaser (long)
 Option Writer (short)
CALL PUT
The RIGHT, but not the

The RIGHT, but not the obligation
obligation to BUY 100
to SELL 100 shares of the
LONG shares of the underlying
underlying asset at a certain strike
asset at a certain strike
price.
price.
The potential
The potential OBLIGATION to
OBLIGATION to SELL
SHORT BUY 100 shares of the asset upon
100 shares of the asset
demand.
upon demand.
1. Option basics
Options exist on variety of underlying assets
• Different underlyings give rise to many different

options:
 Stock Options
 Index Options
 Futures Options
 Foreign Currency Options
 Interest Rate Options

Table of Contents
1. Option basics
3. Put-call parity

At expiration, option price equals its intrinsic price
Valuing an option at expiration (t = T)

• On expiry date, option price equals intrinsic value.
• Intrinsic value: Option payoff if option expired
immediately:
 maximum of zero and the value the option would have if
it were exercised immediately.
 For a call option: max(ST – K, 0).
 For a put option: max(K – ST, 0).

Payoff diagrams for long/short calls/puts at expiration
Long Call; max(ST-K,0) Long Put; max(K-ST,0)

K
Payoff
Payoff
Price of Price of
underlying ST underlying ST
K K
Short Put ; -max(K-ST,0)

Short Call; -max(ST-K,0)
K Price of K Price of
Payoff
Payoff
underlying ST underlying ST

In this example, assume a call option on IBM stock
Example 1: Profit and loss on a Call

• A January 2016 call on IBM with an exercise price of
$195 was selling on December 2, 2015, for $3.65.
• The option expires on the third Friday of the month, or
January 15, 2016.
• If IBM remains below $195, the call will expire
worthless.

Option profitable if IBM price above strike + premium
Example 1: Profit and loss on a Call (cont’d)

• Suppose IBM sells for $197 on the expiration date.
• Option value = stock price – exercise price
$197- $195= $2
• Profit = Final value – Original investment
$2.00 - $3.65 = -$1.65
• Option will be exercised to offset loss of premium.
• Call will not be strictly profitable unless IBM’s price
exceeds $198.65 (strike + premium) by expiration.
A put option gains in value if underlying price falls
Example 2: Profit and loss on a Put

• Consider a February 2016 put on IBM with an exercise
price of $195, selling on January 18, for $5.00.
• Option holder can sell a share of IBM for $195 at any
time until February 15.
• If IBM goes above $195, the put is worthless.

Option profitable if IBM price below strike - premium
Example 2: Profit and loss on a Put (cont’d)

• Suppose IBM’s price at expiration is $188.
• Value at expiration = exercise price – stock price:
$195 - $188 = $7
• Investor’s profit:
$7.00 - $5.00 = $2.00
• Holding period return = 40% (2/5) over 28 days!

Can use options for hedging and speculation
• Derivatives Markets: allow market participants to

trade/reallocate different types of risk in the economy.
• Use options for hedging and speculating
 1) Hedging (insurance): reducing riskiness of cash flows
 40% of Mexico’s revenues come from Pemex.
 To avoid spending cuts, can buy put options to ensure
minimum price (protective put).
 2) Speculation (betting): Not necessarily a bad thing

 In 2000, you saw Palm was overvalued relative to 3-Com.
 For some reason, it was hard to short Palm.
 Could have bought put options on Palm stock instead.
Combining stock with put option creates protective put
1) Portfolio insurance (hedging): E.g., Protective put

• You have 100 shares of MSFT stock at $46, for a total
investment of $4600.
• Buy a MSFT put option with K=45 on 100 shares.
 If MSFT tanks to $35, then you have:
 35*100 + 10*100=$4500 (less the cost of the put).
 $100 difference btw. $4600 and $4500 is “deductible”
 Without insurance would have 100*35=$3500.
• The put costs far less than $1000 loss you would make.

Insure against stock price drop via put option
Put
• Protective Put
 Long position in put held on stock you already own.
• Portfolio Insurance
 Protective put written on portfolio rather than single stock.
Popular use of options to speculate are volatility bets
2) Speculation: Volatility bets (using option combination)

• Straddles and Strangles
 Combinations of long calls and equal numbers of long
puts.
 Straddles: put and call have same strike price.
 Strangles: call has higher strike price.
 Makes sense if you think the stock price is going to
move, but you are not sure in which direction.
• Spreads: same asset, different K or T.
 Bull Spread: Long call (lower K) and short call (higher
K)
In Straddle, trader does not know direction of move
Straddle
Portfolio that is long a call option and a put option on the same stock with
the same exercise date and strike price
Table of Contents
1. Option basics
3. Put-call parity

3. Put-call parity
In efficient market, arbitrage ensures law of one price
Law of one price

• In efficient market, identical securities (same PV of
cash flows) must sell for same price no matter how they
are created.
 E.g., if payoff of security can be created using two
different securities (synthetic replication), then price of
individual and synthetic security must be the same.
• Otherwise, arbitrage opportunity exists:
 involves simultaneous buying and selling of a security at
two different prices in two different markets, with the
aim of creating profits without risk.
3. Put-call parity
Example of profitable arbitrage strategy
Example – Arbitrage profit

• What if the two assets that should have the same price
today are selling for different prices.
• Assume that we have A0 > B0 where AT = BT.
Action Today (t = 0) Cash Flow Today (t = 0) Cash Flow Later (t = T)
Sell asset A (short) + A0 -AT
Buy asset B -B0 + BT
Outcome A0 – B0 0
• Note that A0 – B0 > 0, which means you make arbitrage

profit.
3. Put-call parity
Is there a relation between call and put option prices?
• Can we replicate “protective put payoff” (orange) by

using call option? Yes!
Riskless Bond + Call
Riskless Bond
Put Call
Synthetic replication: invest in

zero-coupon risk-free bond and
European call option on same
stock as in Protective put.
3. Put-call parity
Is there a relation between call and put option prices?
• Have shown two ways to construct portfolio insurance:

 Purchase the stock and a put
 Purchase a bond and a call
• Both positions provide exactly the same payoff.
• Law of One Price requires they must have same price.
• Therefore:
S +=
P PV (K ) + C

3. Put-call parity
Example: how can we replicate European call option?
Example: Put-call parity arbitrage

• Suppose a stock pays no dividends, and that the riskless
interest rate is r.
• What are the payoffs in one year from the following
investment strategy:
 Buy one share.
 Buy a European put option with exercise price K.
 Borrow the present value of K.

3. Put-call parity
Call option related to stock, put and borrowed funds

Present date Expiration date
S*< K S* > K
Buy stock -S S* S*
Buy Put -P K - S* 0
Borrow K/(1+r) -K -K
Total - S - P + K/(1+r) 0 S* - K
• Payoff of portfolio is identical to that of European call

option.
• Price of call option must therefore equal total cost of
the portfolio.
3. Put-call parity
…, i.e. price of call equals put plus stock minus bank
Put-call parity
• Rearranging terms gives expression for price of a
European call option for a non-dividend-paying stock.
C = P + S − PV (K )
• Price of E-call option for dividend-paying stock:
C = P + S − PV (K ) − PV (Div)
Relationship between value of the stock, the bond, and

call and put options is known as put-call parity.
3. Put-call parity
Violation of put-call parity implies arbitrage profits

Put-call parity example:
P = 10, S = 100, K = 100, T =1, rf = 6%.
Call price should be: C = 10+100-100/(1.06) = 15.66
Suppose the call trades at 17. Construct the arbitrage.
Today Maturity
position ST ≤ K ST ≥ K
Call Sell: +17 0 100-ST
Put Buy: -10 100-ST 0
Stock Buy: -100 ST ST
Bond Sell: +94.34 -100/(1+rf)×(1+r1) -100/(1+rf)×(1+r1)
Net +1.34 0 0
3. Put-call parity
In this example, calculate put price based on data
Example: Put-call parity pricing

• Assume the following information for Microsoft shares
and calls:
 S0= 26.50
 K=27.50
 C0=0.20
 T=1/12
 Rf=3% (per year (APR), monthly compounded).
• Calculate the prevailing European put price.

3. Put-call parity
Put-call parity allows calculating put price
Example: Put-call parity pricing – Solution

 S0= 26.50
 K=27.50
 C0=0.20
 T=1/12
 Rf=3% (per year (APR), monthly compounded).
0.20 − P0 = 26.50 – 27.50/(1.0025)

P0= 0.20 + 27.43 – 26.50 = 1.13

Table of Contents
1. Option basics
3. Put-call parity

Before expiration, several factors affect option prices
Valuing an option before expiration (t < T)

• More complicated than valuing the option at maturity.
 Need to identify the factors that affect option prices.
 Stock price
 Exercise (strike) price
 Time to expiration
 Risk-free interest rate (between now and expiration)
 Volatility of the stock price (between now and expiration)
 Expected dividends (between now and expiration)
Next, let’s find out how do these factors affect the price
of a stock option…
Here is a brief overview of option price determinants
European European American American

Factor
Call Put Call Put
Stock price + - + -
Exercise price - + - +
Time to maturity ? ? + +
Risk-free rate + - + -
Volatility + + + +
Dividends - + - +

Option price before expiration includes time value
Time value
= Difference between option’s price and intrinsic value.
• Any call option on non-dividend paying stock always
has positive time value.
C =  −
SK + dis (K ) + P
 
Intrinsic value Time value
dis(K) = amount of discount from face value of zero-coupon bond K.

Table of Contents
1. Option basics
3. Put-call parity

Can value options with Binomial Pricing Model
Key insight in this section

• Pricing technique: Binomial Option Pricing Model
 Based on assumption that each period, stock’s return can
take on only two values.
• Will derive option value through law of one price:

 Option payoff in one period can be replicated by a
portfolio consisting of a stock and a risk-free bond.
 Replicating portfolio technique.

Binomial model assumes price takes on two values
Binomial pricing: backdrop

• A European call option expires in one period and has an
exercise price of $50.
• Stock price today = $50; stock pays no dividends.
• In one period, stock price will either rise by $10 or fall
by $10.
• Assume you also hold a risk-free bond. The one-period
risk-free rate is 6%.
Will summarize this information in a Binomial Tree.

Stock price either goes up or down: no probabilities!
Binomial pricing: tree
0 1
Stock Bond Call
60 1.06 max(60-50,0) = 10
Stock 50
Bond 1
40 1.06 max(40-50,0) = 0

Can create portfolio that replicates option price
Binomial pricing: solving for delta and B

• In the up state, the value of the portfolio must be $10.
60∆ + 1.06Β = 10
• In the down state, the value of the portfolio must be $0.
40∆ + 1.06Β = 0
• Will see that ∆ and B are the following:
∆ = 0.5
B = –18.8679
Prices of replicating portfolios must equal option price
Binomial pricing: price of call

• In words: portfolio that is long 0.5 share of stock and
short approximately $18.87 worth of bonds will have
value in one period that exactly matches value of call.
60 × 0.5 – 1.06 × 18.87 = 10
40 × 0.5 – 1.06 × 18.87 = 0
• Value of the portfolio today:
50∆ + Β = 50(0.5) − 18.87 = 6.13

Can generalize the formula for call and put options
Binomial pricing: Generalized formula
0 1
Stock Option
Su Cu
• Bond (not shown)
earns risk free
S rate rf.
Sd Cd • u = up; d = down
• Payoffs of replicating portfolios could be written as:
Su∆ + (1+ rf)B = Cu and Sd∆ + (1+ rf)B = Cd

Delta provides number that must be invested in stock
Binomial pricing: Generalized formula

• Solving the two replicating portfolio equations for the
two unknowns D and B yields general formula for the
replicating formula in the binomial model.
1) Su∆ + (1+ rf)B = Cu
𝐶𝐶𝑢𝑢 −𝐶𝐶𝑑𝑑 𝐶𝐶𝑑𝑑 −𝑆𝑆𝑑𝑑 ∆
∆= and 𝐵𝐵 = B = (Cu – Su∆) / (1+ rf)
𝑆𝑆𝑢𝑢 −𝑆𝑆𝑑𝑑 1+𝑟𝑟𝑓𝑓
2) Sd∆ + (1+ rf)B = Cd
Sd∆ + Cu – Su∆ = Cd
• The value of the option is: Cu-Cd = ∆(Su -Sd)
(Cu-Cd) / (Su -Sd) = ∆
C = S∆ + B 2) Sd∆ + (1+ rf)B = Cd

B = (Cd- Sd∆) / (1+ rf)
Can extend one period binomial model to multiperiod
Binomial pricing: Multiperiod model

• To calculate the value of an option in a multiperiod
binomial tree, start at the end of the tree and work
backwards.
Call
10
6.13
0
0

We solve multiperiod binomial model backwards
Binomial pricing: Multiperiod model

• Final step is to determine value of the option at time 0.
𝐶𝐶𝑢𝑢 − 𝐶𝐶𝑑𝑑 6.13 − 0

∆= = = 0.3065
𝑆𝑆𝑢𝑢 − 𝑆𝑆𝑑𝑑 50 − 30
𝐶𝐶𝑑𝑑 − 𝑆𝑆𝑑𝑑 ∆ 0 − 30(0.3065)
𝐵𝐵 = = = −8.67
1 + 𝑟𝑟𝑓𝑓 1.06
Initial option value at time 0:

C = S∆ + B = 40×0.3065 – 8.67 = $3.59

Table of Contents
1. Option basics
3. Put-call parity

Binomial model too simplistic with up/down movement
• Binary up or down movements not super realistic.

• But: by decreasing length of each period, and
increasing number of periods in the stock price tree, a
realistic model for the stock price can be constructed.
• Black-Scholes Option Pricing Model
 Technique for pricing European-style options when stock
can be traded continuously.
 Can be derived from the Binomial Option Pricing Model
by allowing the length of each period to shrink to zero
and letting the number of periods grow infinitely large.

Black-Scholes model makes periods infinitely small
• Limiting case of binomial formula

 Periods get shorter, more frequent
=c S0 N (d1 ) − Ke − rT N (d 2 )
ln( S0 / K ) + (r + σ 2 / 2)T
d1 =
σ T
ln( S0 / K ) + (r − σ 2 / 2)T
d= = d1 − σ T
σ T
2
• Interpreting the formula:

 N(d1): number of shares in tracking portfolio = delta Δ
 B = -Ke-rTN(d2) = risk-free borrowing
Examples from the cumulative normal distribution
• N(d1) and N(d2) represent area under a standard normal

curve to the left of d1 and d2.
N(x) is area under the
curve to the left of x
0 x
• Example: (open “Table for N(d).pdf” on Blackboard)
 Assume d1 = -0.3070. What is N(d1)?

 N(d1) = 0.3798 (average N(x) of x=-0.30 and x=0.31).
 Assume d2= -0.5056. What is N(d2)?

 N(d2) = 0.3068 (average N(x) of x=-0.50 and x=-0.51).
Black-Scholes inputs observable except volatility
• Note: Only five inputs are needed for the Black-

Scholes formula.
 Stock price
 Strike price
 Exercise date
 Risk-free rate
 Volatility of the stock

Implied volatility in BS-formula is not observable
• Of the five required inputs in the Black-Scholes

formula, only σ is not observable directly.
 Practitioners use two strategies to estimate value of σ.

 Use historical data
 “Back out” the implied volatility
– Implied Volatility
» The volatility of an asset’s returns that is consistent with
the quoted price of an option on the asset

What we have learned today
What we have learned today
• What are long/short call and put options.

• What is the difference between American and
European-style options.
• What factors impact the value of an option before
expiration.
• Value options via the Binomial Pricing Model.
• Understand key features of the Black-Scholes model.

Foundations of Finance (BMAN23000)

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Foundations of Finance

Dr. Stefan Petry

1 Capital budgeting and risk Payout policy

2 Options and option valuation 6 Real options

3 Capital structure I 7 Equity and debt financing

Stefan Petry BMAN23000 Semester 2, 2021/22 2 / 55

Options and option valuation

Stefan Petry BMAN23000 Semester 2, 2021/22 3 / 55

Stefan Petry BMAN23000 Semester 2, 2021/22 4 / 55

After the lecture, you will be able to:

Stefan Petry BMAN23000 Semester 2, 2021/22 5 / 55

Derivatives derive value from prices of other assets

• Derivatives are securities that derive their value from

In this course, focus on options and their valuation.

Stefan Petry BMAN23000 Semester 2, 2021/22 6 / 55

Stefan Petry BMAN23000 Semester 2, 2021/22 7 / 55

Options give right but not obligation to deal with asset

Call option Put option

Stefan Petry BMAN23000 Semester 2, 2021/22 8 / 55

Important options terminology to remember

In-the-money option Exercise of option produces positive cash flow

Option agreement consists of long and short side

• Two sides to Exchange Traded Option Agreement

The RIGHT, but not the

Options exist on variety of underlying assets

• Different underlyings give rise to many different

Stefan Petry BMAN23000 Semester 2, 2021/22 11 / 55

Stefan Petry BMAN23000 Semester 2, 2021/22 12 / 55

At expiration, option price equals its intrinsic price

Valuing an option at expiration (t = T)

Stefan Petry BMAN23000 Semester 2, 2021/22 13 / 55

Payoff diagrams for long/short calls/puts at expiration

Long Call; max(ST-K,0) Long Put; max(K-ST,0)

Short Put ; -max(K-ST,0)

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In this example, assume a call option on IBM stock

Example 1: Profit and loss on a Call

Stefan Petry BMAN23000 Semester 2, 2021/22 15 / 55

Option profitable if IBM price above strike + premium

Example 1: Profit and loss on a Call (cont’d)

A put option gains in value if underlying price falls

Example 2: Profit and loss on a Put

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Option profitable if IBM price below strike - premium

Example 2: Profit and loss on a Put (cont’d)

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Can use options for hedging and speculation

• Derivatives Markets: allow market participants to

 2) Speculation (betting): Not necessarily a bad thing

Combining stock with put option creates protective put

1) Portfolio insurance (hedging): E.g., Protective put

Stefan Petry BMAN23000 Semester 2, 2021/22 20 / 55

Insure against stock price drop via put option

Popular use of options to speculate are volatility bets

2) Speculation: Volatility bets (using option combination)

In Straddle, trader does not know direction of move

Stefan Petry BMAN23000 Semester 2, 2021/22 24 / 55

In efficient market, arbitrage ensures law of one price

Law of one price

Example of profitable arbitrage strategy

Example – Arbitrage profit

• Note that A0 – B0 > 0, which means you make arbitrage

Is there a relation between call and put option prices?