Chapter 22

Options and Corporate Finance

 Understand option terminology
 Be able to distinguish between Call and Put options
 Be able to determine option payoffs and profits
 Be able to understand how equity and debt as Option
 Be able to understand how real investment as Option

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22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Option Quotes
22.9 Stocks and Bonds as Options
22.11 Investment in Real Projects and Options

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22-3
 An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or before) a
given date, at prices agreed upon today.
 Exercising the Option
◦ The act of buying or selling the underlying asset
 Strike Price or Exercise Price
◦ Refers to the fixed price in the option contract at which the holder can
buy or sell the underlying asset
 Expiry (Expiration Date)
◦ The maturity date of the option

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 European versus American options
◦ European options can be exercised only at expiry.
◦ American options can be exercised at any time up to expiry.
 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.

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 Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset
on or before some time in the future, at prices
agreed upon today.
 When exercising a call option, you “call in” the
asset.

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 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 ST – E.
◦ If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the call option at expiry

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 a ll
60

ac
y
Option payoffs ($)

Bu
40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50

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 60
Option profits ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50; option premium = $10

–40

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 Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset on
or before some time in the future, at prices agreed
upon today.
 When exercising a put, you “put” the asset to
someone.

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 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 E – S .
T
 If the put is out-of-the-money, it is worthless.

P = Max[E – ST, 0]

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22-11
 60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40
Exercise price = $50
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22-12
 60
Option profits ($)

40

20

10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10

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22-13
 Intrinsic Value
◦ Call: Max[ST – E, 0]
◦ Put: Max[E – ST , 0]
 Speculative Value
◦ The difference between the option premium and the
intrinsic value of the option.

Option Intrinsic + Speculative

=
Premium Value Value

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 The seller (or writer) of an option has an obligation.

 The seller receives the option premium in exchange.

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 60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20
Se
ll
ac
–40 Exercise price = $50 all

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22-16
 40
Option payoffs ($)

20

Sell a put
0
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

–50

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Option profits ($)

40 Buy a call

Sell a call
10

Stock price ($)

Buy a call 40 50 60 100
–10

Exercise price = $50;

–40 Sell a call
option premium = $10

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Option profits ($)

40

Bu
y
ap
ut

10 Sell a put

Stock price ($)

40 50 60 100
–10 Buy a put

u t
a p
e ll
S
Exercise price = $50;
–40
option premium = $10

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22-19
 --Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05

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22-20
This option has a strike price of $170;
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05
a recent price for the stock is $167.30;
July is the expiration month.
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 This makes a call option with this exercise price out-of-
the-money.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05
Puts with this exercise price are in-the-money by $2.70
= $170 - $167.30.
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 --Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05

On this day, 212 call options with this exercise price were
traded.

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22-23
The CALL option with a strike price of $170 is trading for $1.25.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05
Since the option is on 100 shares of stock, buying this option
would cost $125 plus commissions.
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22-24
 --Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05
On this day, 335 put options with this exercise price were
traded.

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22-25
The PUT option with a strike price of $170 is trading for $3.95.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 162.5 Jul 21 5.85 145 0.89
167.3 165 Jul 108 3.95 150 1.48
167.3 170 Jul 212 1.25 335 3.95
167.3 170 Aug 1449 3.15 1518 6.75
167.3 170 Sep 156 3.91 264 7.71
167.3 175 Sep 101 2.18 78 11.05
Since the option is on 100 shares of stock, buying this
option would cost $395 plus commissions.
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22-26
 Levered equity is a call option.
◦ The underlying asset comprises the assets of the firm.
◦ The strike price is the payoff of the bond.
 If at the maturity of their debt, the assets of the firm
are greater in value than the debt, the shareholders
have an in-the-money call. They will pay the
bondholders and “call in” the assets of the firm.
 If at the maturity of the debt the shareholders have
an out-of-the-money call, they will not pay the
bondholders (i.e. the shareholders will declare
bankruptcy) and let the call expire.

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 Levered equity is a put option.
◦ The underlying asset comprises the assets of the firm.
◦ The strike price is the payoff of the bond.
 If at the maturity of their debt, the assets of the firm are
less in value than the debt, shareholders have an in-the-
money put.
 They will put the firm to the bondholders.
 If at the maturity of the debt the shareholders have an
out-of-the-money put, they will not exercise the option
(i.e. NOT declare bankruptcy) and let the put expire.

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 ClassicNPV calculations generally ignore
the flexibility that real-world firms
typically have.
◦ Option to expand
◦ Option to abandon

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 What is the difference between call and put options?
 How can equity be viewed as a call option?
 How can debt be viewed as a call option?
 Should management ever accept a negative NPV
project? If yes, under what circumstances?

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