20UO Master 311020

CORPORATE FINANCE
20. Understanding options
20-1 Calls, puts, and shares
Corporate Finance II José A. de Azevedo Pereira 2
1
• Call Option
• Right to buy an asset at specified price on or before
exercise date
• Put Option
• Right to sell asset at specified price on or before
exercise date
• Option Obligations
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
2
• Derivative
• Financial instrument created from another instrument
• Option Price
• Price paid for option
• Intrinsic Value
• Difference between strike price and stock price
• Time Premium
• Value of option above intrinsic value
• Exercise Price (Strike Price)

• Price at which security is bought or sold
• Expiration Date
• Last date on which option can be exercised
• American Call
• Can be exercised any time up to expiration date
• European Call
• Can only be exercised on expiration date
3
Options
 In-the-Money
 Exercising the option would result in a positive payoff.
 At-the-Money
 Exercising the option would result in a zero payoff (i.e., exercise price
equal to spot price).
 Out-of-the-Money
 Exercising the option would result in a negative payoff.
Corporate Finance II J. Azevedo Pereira 7
Table 20.1 Options on Apple stock, October 2011

American options
Selected prices of put and call

options on Apple, in October
2011, when the stock price
was about $400.
4
• Option Value
• Value at expiration is a function of stock price and
exercise price
• Example
• Option values given exercise price of $80
Stock Price $60 70 80 90 100 110

Call value 0 0 0 10 20 30
Put value 20 10 0 0 0 0
Call Option Pricing at Expiry

 At expiry, an American call option is worth the same
as a European option with the same characteristics.
 If the call is in-the-money, it is worth PT – S.
 If the call is out-of-the-money, it is worthless:
C = Max[PT – S, 0]
Where
PT is the value of the stock at expiry (time T)
S is the exercise price (strike price).
C is the value of the call option at expiry
10
5
Figure 20.1a Apple position diagram, call
• Call Option
• Possible consequences of investing in Apple April 2012 call options with an exercise
price (strike price) of $400 => [f(stock price)]
11
Put Option Pricing at Expiry

 At expiry, an American put option is worth
the same as a European option with the
same characteristics.
 If the put is in-the-money, it is worth S – PT.
 If the put is out-of-the-money, it is
worthless.
P = Max[S – PT, 0]
12
6
Figure 20.1b Apple position diagram, put
• Call Option
• Possible consequences of investing in Apple April 2012 put options with an exercise
13
Figure 20.2a Payoff to seller of apple call

• Possible consequences of selling Apple April 2012 call options with an exercise
Position diagrams
show only the
payoffs at the
moment when the
option is exercised.
They do not take
into consideration
the initial cost of
buying the option
or the transaction
costs paid.
14
7
Figure 20.2b Payoff to seller of apple put
• Possible consequences of selling Apple April 2012 put options with an exercise
Position diagrams
show only the
payoffs at the
moment when the
option is exercised.
They do not take
into consideration
the initial cost of
buying the option
or the transaction
costs paid.
15
Table 20.1 Options on Apple stock, October 2011
16
8
Figure 20.3a Profit diagram for Apple
17
Figure 20.3b Profit diagram for Apple
18
9
Option Value
 Intrinsic Value
 Call: Max[PT – S, 0]
 Put: Max[S – PT , 0]
 Speculative Value
 The difference between the option premium and the
intrinsic value of the option.
Option Intrinsic + Speculative

=
Premium Value Value
19
Option Quotes
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
20
10
Option Quotes
This option has a strike price of $135;

--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
a recent price for the stock is $138.25;
July is the expiration month.
21
Option Quotes
This makes a call option with this exercise price in-the-

money by $3.25 = $138¼ – $135.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Puts with this exercise price are out-of-the-money.
22
11
Option Quotes
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,365 call options with this exercise price were
traded.
23
Option Quotes
The CALL option with a strike price of $135 is trading for $4.75.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions.
24
12
Option Quotes
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,431 put options with this exercise price were
traded.
25
Option Quotes
The PUT option with a strike price of $135 is trading for $.8125.
--Call-- --Put--
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions.
26
13
Combinations of Options
 Puts and calls can serve as the building

blocks for more complex option contracts.
 If you understand this, you can become a
financial engineer, tailoring the risk-return
profile to meet your client’s needs.
27
Option Diagrams Revisited

Option profits ($)
40 Buy a call
10 Sell a call Sell a put
Stock price ($)

40 50 60 100
–10 Buy a call
Buy a put
Exercise price = $50; Sell a call

–40
option premium = $10
28
14
Figure 20.4 Financial alchemy with options: six-month
payoff options, Apple
Financial alchemy:
Strategy b) is clearly better
than strategy a)
However, strategy c) is
worse than, both, a) and b)
29
Figure 20.5 Options

• A strategy for masochists:
• Buy share and sell call => investor loses if stock falls below $400 and does
not win if stock rises above the same $400.
30
15
The cost of your protection is
Figure 20.6 Protection strategies the price paid for the Apple
put, with an exercise price of
$400.
31
• Position Diagram
• Long stock and short call
Long stock
Poor strategy
Position value
Short call
Share price
32
16
• Protective put: long stock and long put
Long stock
Protective put
Position value
Long put
Share price
33
• Straddle: long call and long put
Long put Long call

Position value
Straddle
Share price
34
17
20-3 What determines option values?
• Components of Option Price

• Underlying stock price = Ps
• Striking or exercise price = S
• Volatility of stock returns (standard deviation of annual
returns) = σ
• Time to option expiration = t = days/365
• Time value of money (discount rate) = r
• PV of dividends = D = (div)e−rt
35
Put-Call Parity: Put0 + P0 = C0 + S/(1+ r)T

S Portfolio payoff
Portfolio value today = C0 +
(1+ r)T
Call
Option payoffs ($)
25 bond
25 Stock price ($)

Consider the payoffs from holding a portfolio
consisting of a call with a strike price of $25 and a
bond with a future value of $25.
36
18
Put-Call Parity
Portfolio payoff
Portfolio value today = Put0 + P0
Option payoffs ($)
25
Stock price ($)

25
Consider the payoffs from holding a portfolio consisting

of a share of stock and a put with a $25 strike.
37
Put-Call Parity
Portfolio value today
Option payoffs ($)
Portfolio value today

Option payoffs ($)
S = Put0 + P0
= C0 +
(1+ r)T
25 25
25 Stock price ($) 25 Stock price ($)
Since these portfolios have identical payoffs, they must have

the same value today: hence
Put-Call Parity: C0 + S/(1+r)T = P0 + Put0
38
19
Figure 20.7 call to put
• Homemade put created base on the put-call parity with six month securities:
400 = - $37.23
-$44.05 − + $400
1.035 , Cost of
homemade
put
39
Spotting the option
The Flatiron and Mangle Corporation has offered its president, Ms.
Hidgen the following incentive scheme: at the end of the year, Ms.
Hidgen will be paid a bonus of $50,000 for every dollar that the price
of the stock exceeds its current figure of $120. However the
maximum amount she can get is set at $2 million.
40
20
Figure 20.8 Ticket payoff
It is possible to think of Ms. Hidgen as owning 50,000 tickets, each of which is paying nothing if the
stock price fails to beat $120. The value of each ticket then rises $1 for each dollar rise in the stock
$ , ,
price up to a maximum rise of = $40.
,
The whole
package can be
understood as a
combination of
options
41
Figure 20.9 Call purchase and sale

Purchase of a call
option with an
exercise price of
$120
Sale of a call option

with an exercise
price of $160
42
21
• Components of Option Price

• Underlying stock price = Ps
• Striking or exercise price = S
• Volatility of stock returns (standard deviation of annual
returns) = σ
• Time to option expiration = t = days/365
• Time value of money (discount rate) = r
• PV of dividends = D = (div)e−rt
43
Time decay chart
• Option price decreases, all other things equal, as

time to expiration decreases
Option price 30 days to expiration
90 days to expiration
60 days to expiration
Stock price
44
22
Stock price
Upper limit
Lower limit
(Stock price - exercise price) or 0,

whichever is higher
45
Figure 20.10 Value of call before expiration date
46
23
FIGURE 20.11 CALL OPTIONS, FIRMS X AND Y
• In each case, current share

price equals exercise price;
each option has 50%
chance of success or
failure
• Firm Y has greater chance
of large payoff because it is
more volatile
20-47
47
American Call
Profit PT
Call
Option payoffs ($)
25
Market Value
Time value
Intrinsic value
PT
S
Out-of-the-money In-the-money
loss
Corporate Finance II
C0 must fall within max (P0 – S, 0) < C0 < P0.
J. Azevedo Pereira 48
48
24
Option Value Determinants
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate + –
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option C0 must fall within
max (P0 – S, 0) < C0 < P0.
The precise position will depend on these factors.
49
Figure 20.12 Apple call option value versus stock price
50
25
Table 20.2 Determinants of call price
51
Table 20.3 Executive stock options
52
26
Thank You
53
27

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CORPORATE FINANCE

20. Understanding options

20-1 Calls, puts, and shares

Corporate Finance II José A. de Azevedo Pereira 2

Corporate Finance II José A. de Azevedo Pereira 3

20-1 Calls, puts, and shares

Corporate Finance II José A. de Azevedo Pereira 4

Corporate Finance II José A. de Azevedo Pereira 5

20-1 Calls, puts, and shares

• Exercise Price (Strike Price)

Corporate Finance II José A. de Azevedo Pereira 6

Corporate Finance II J. Azevedo Pereira 7

Table 20.1 Options on Apple stock, October 2011

Selected prices of put and call

Corporate Finance II José A. de Azevedo Pereira 8

Stock Price $60 70 80 90 100 110

Corporate Finance II José A. de Azevedo Pereira 9

Call Option Pricing at Expiry

Corporate Finance II José A. de Azevedo Pereira 11

Put Option Pricing at Expiry

Corporate Finance II J. Azevedo Pereira 12

Corporate Finance II José A. de Azevedo Pereira 13

Figure 20.2a Payoff to seller of apple call

Corporate Finance II José A. de Azevedo Pereira 14

Corporate Finance II José A. de Azevedo Pereira 15

Table 20.1 Options on Apple stock, October 2011

Corporate Finance II José A. de Azevedo Pereira 16

Corporate Finance II José A. de Azevedo Pereira 17

Figure 20.3b Profit diagram for Apple

Corporate Finance II José A. de Azevedo Pereira 18

Option Intrinsic + Speculative

This option has a strike price of $135;

This makes a call option with this exercise price in-the-

 Puts and calls can serve as the building

Option Diagrams Revisited

10 Sell a call Sell a put

Stock price ($)

Exercise price = $50; Sell a call

Corporate Finance II José A. de Azevedo Pereira 29

Figure 20.5 Options

Corporate Finance II José A. de Azevedo Pereira 30

Corporate Finance II José A. de Azevedo Pereira 31

20-1 Calls, puts, and shares

20-1 Calls, puts, and shares

Long put Long call

• Components of Option Price

Corporate Finance II José A. de Azevedo Pereira 35

Put-Call Parity: Put0 + P0 = C0 + S/(1+ r)T

25 Stock price ($)

Stock price ($)

Consider the payoffs from holding a portfolio consisting

Portfolio value today

25 Stock price ($) 25 Stock price ($)

Since these portfolios have identical payoffs, they must have

Spotting the option

Corporate Finance II José A. de Azevedo Pereira 40

Corporate Finance II José A. de Azevedo Pereira 41

Figure 20.9 Call purchase and sale

Sale of a call option

Corporate Finance II José A. de Azevedo Pereira 42

• Components of Option Price

Corporate Finance II José A. de Azevedo Pereira 43