25-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
25-2
Chapter 25
Options
Chapter Outline
Calls and Puts
 What Determines Option Values
 Spotting the Option

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25-3
Calls and Puts
• What
is an Option?
An option gives the holder (purchaser)
of that option the right, but not the
obligation, to do something at a future
date.
 In finance, there are two types of
options you will have to deal with:

Call
Options
Put Options
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Calls and Puts
• What is an Option?
 Call Options
A call option is the right to buy an
asset at a specified exercise price on
or before the exercise date.
 Put Options
A put option is the right to sell an
asset at a specified exercise price on
or before the exercise date.
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Calls and Puts
• Call


Options
You buy a call option on ABC shares, which
gives you the right to buy an ABC share for $30
(the exercise price) on or before December
31st of the current year.
If you have the right to buy an ABC share, then
someone must have the obligation to sell it
to you if you want to buy it.
 The
person who is obligated to sell the asset to
you is known as the seller or writer of the call
option.
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25-6
Calls and Puts
• Put


Options
You buy a put option on ABC shares, which
gives you the right to sell an ABC share for $30
(the exercise price) on or before December
31st of the current year.
If you have the right to sell an ABC share, then
someone must have the obligation to buy it
from you if you want to sell.
 The
person who is obligated to buy the asset
from you is known as the seller or writer of the
put option.
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Calls and Puts
• Calls

and Puts
To summarize:
Call Option
Put Option

Buyer
Right to buy asset
Right to sell asset
Seller
Obligation to sell asset
Obligation to buy asset
The seller of the option must be compensated
for taking on the obligation.


Thus, the buyer of the option must pay a price
for the option.
The price of an option is called its premium.
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25-8
Calls and Puts
• Calls


and Puts
The value of an option at expiration is a
function of the asset’s price and the exercise
price.
Assuming the exercise price is $30 and ABC
shares have the following values, then at
expiry, the following would occur:
Stock Price
Call Value
$20
$0
$25
$0
$30
$0
$35
$5
$40
$10
$45
$15
Put Value
$10
$5
$0
$0
$0
$0
copyright © 2003 McGraw Hill Ryerson Limited
25-9
Calls and Puts
Summary: Valuing Calls and Puts
Stock Price
at Expiration
Call Option
Greater than
exercise price
Less than
exercise price
Put Option
Greater than
exercise price
Less than
exercise price
Value of Option
at Expiration
Stock Price – Exercise Price
Zero
Zero
Exercise Price – Stock Price
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25-10
Calls and Puts
• Value



Diagrams
Sometimes it is easier to draw a diagram of an
option to understand the pay-offs to the buyer
and the seller of the option.
In each of the diagrams which follows, the
option has an exercise price of $30 and allows
the holder to buy or sell one ABC share.
Note: For simplicity, the premium is assumed
to be zero in each of the diagrams.
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25-11
Option Value
Call option value
Call option value to buyer given
a $30 exercise price.
$10
?
20
30
40
Share Price
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25-12
Option Value
Put option value
Put option value to a buyer given a $30
exercise price.
$30
$10
?
20
30
40
Share Price
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25-13
Option Value
Call option $ payoff
Call option pay-off to seller (writer)
given a $30 exercise price.
-$10
?
30
40
Share Price
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25-14
Option Value
Put option $ payoff
Put option pay-off to seller (writer)
given a $30 exercise price.
-$10
?
-$30
20
30
Share Price
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25-15
Financial Alchemy with Options
• Protective



Put
Now we will look at how options can be used to
modify the risk characteristics of a portfolio.
Suppose you are generally optimistic about
ABC’s prospects, but that you don’t like high
levels of risk.
You buy the stock and you also buy a put
option with a $30 exercise price.
 If
the stock price rises, your option will be
worthless.
 If the stock price falls, however, your losses are
limited to $30 since the put option gives you the
right to sell the stock for $30.
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25-16
Financial Alchemy with Options
• Protective


Put
Because you hold the stock and the put, your
losses are limited to $30.
The value of each component will be as
follows:
Value of Stock
+ Value of Put
Total Value
Stock Price < $30
Stock price
$30 - stock price
$30
Stock Price  $30
Stock price
0
Stock Price
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25-17
Financial Alchemy with Options
• Protective



Put
This strategy is called a protective put because
the put option protects you from losses.
In effect, you have purchased stock price
insurance.
Note that such protection is not free:
 You
will have to pay a premium to purchase the
put.
 If the premium for this option is $2.15, then your
insurance against the stock falling below $30 a
share will have cost you $2.15.
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25-18
Financial Alchemy with Options
Protective Put – Long Stock and Long Put
Position Value
Long the Stock
Protective Put
Long Put
Share Price
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25-19
Financial Alchemy with Options
• Straddle

Suppose you think that ABC will be subject to
considerable volatility over the next couple of
months.
 How
can you bet on the expected volatility of the
stock?


A straddle is a strategy for profiting from high
volatility.
A straddle involves purchasing a put and a call.
 If
the stock price falls, the put will be profitable.
 If the stock price rises, the call will be profitable.
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25-20
Financial Alchemy with Options
• Straddle

There is a cost to your strategy: you will have
to pay a premium for the call and for the put.
 Unless
the stock price moves far enough that
the profit on either the put or call covers the
initial cost of the two options, you will lose
money.


The net position of the strategy is shown by the
dashed V-shaped line on the next slide,
The profit, taking into account the premiums on
the this strategy, is shown by the solid Vshaped line on the next slide.
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25-21
Financial Alchemy with Options
Straddle – Long Call and Long Put
Position Value
Long Call
Straddle
Long Put
Share Price
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25-22
Financial Alchemy with Options
• Other
Strategies
There are many other option strategies
which can be pursued.
 Combining options with various assets,
gives you considerable leeway to tailor
the risk features of a portfolio.
 For practice, try Check Point 25.3 on
page 745 of your text.

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25-23
What Determines Option Values?
• Upper

and Lower Limits of Option Value
The upper limit on the value of a call option is
the stock price itself.
 Thus,
the option cannot be worth more than the
asset it entitles you to buy.

The lower limit on the value of a call option is
the value of the call at expiry.
 After
expiry, any option is valueless.
 At expiry the option has its lowest value.
 Thus, before expiry, the value of an option
cannot be less than its value at expiry.

These limits can be seen on the next slide.
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25-24
Option Value
Upper and Lower Limits on Option Values
Call option value
Value of the Stock
Value of Option
before expiry
Value of Option
at Expiry
20
30
40
Share Price
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25-25
What Determines Option Values?
• Upper


and Lower Limits of Option Value
Figure 25.7 on page 746 of your text is a copy
of the previous slide.
If you look at Figure 25.7, you should notice
the following:
 Point
A: When the stock is worthless, the option
is worthless.
 Point B: When the stock price becomes very
high, the option price approaches the stock price
less the present value of the exercise price.
 Point C: The option price before expiry exceeds
its value at expiry.
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25-26
What Determines Option Values?
• Upper

and Lower Limits of Option Value
How high point C is on the graph will be
determined by a number of factors:
 How
High Interest Rates Are
Having a call option is the same as buying the
stock on credit.
 You pay the purchase price of the option, but
you do not have to pay the exercise price for
the stock until you exercise the option.
 The higher interest rates are, the more
valuable this option to delay will be.

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25-27
What Determines Option Values?
• Upper

and Lower Limits of Option Value
How high point C is on the graph will be
determined by a number of factors:
 The
Length of Time Until Expiry
The longer the life of the asset, the greater
the chance that you will find an opportunity to
exercise it.
 Thus, options with a long life are more
valuable than those with a short life.

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25-28
What Determines Option Values?
• Upper

and Lower Limits of Option Value
How high point C is on the graph will be
determined by a number of factors:
 The
Standard Deviation of the Price of the
Stock.
Substantial movement in the price of the stock
is very valuable in an option.
 A stock whose price moves by 1% or 2% is
not worth much.
 A stock whose price halves or doubles is very
valuable.

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25-29
What Determines Option Values?
• Upper


and Lower Limits of Option Value
To see how this works, imagine that ABC has an
equal chance of being worth $25 or $35 at expiry.
The expected value of the option will be:
Stock Price at Expiry


$25
$35
$ 0
$ 5
Avg Value
$2.50
Now imagine that ABC has an equal chance of
being worth $20 or $40 at expiry.
The expected value of the option will be:
Stock Price at Expiry
$20
$ 0
$40
$10
Avg Value
$5.00
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25-30
What Determines Option Values?
• Upper

and Lower Limits of Option Value
These two cases highlight a valuable
asymmetry in options:
 If
the stock price is below the exercise price at
expiry, the option is valueless.

This is true regardless of whether the stock
price is one cent below the exercise price, or
many dollars below it.
 However,
if the stock price is above the
exercise price, the holder reaps all the benefits
of stock price advances.
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25-31
What Determines Option Values?
• Upper
and Lower Limits of Option Value
Thus, in our example, if the stock price is
$35, the option is worth $5.
 But if the stock price jumps to $40, the value
of the option doubles to $10.
 Therefore, volatility helps an option owner.

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25-32
What Determines Option Values?
• What Affects
the Price of a Call Option?
If the following increase:
The value of the call will:
STOCK PRICE
INCREASE
EXERCISE PRICE
DECREASE
INTEREST RATE
INCREASE
TIME TO EXPIRY
INCREASE
VOLATILITY OF THE
STOCK PRICE
INCREASE
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25-33
What Determines Option Values?
• Valuing
Options
Calculating the value of an option is a
difficult undertaking.
 You can see two methods which are used
by reading:

 The
Finance in Action Box on page 750 of
your book.
 Appendix 25A, in which the Black-Scholes
Option Pricing Model is described.
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25-34
Spotting the Option
• Options



on Real Assets
Real options are options embedded in real
assets.
You learned in Chapter 8, that capital
investment projects are more valuable if they
have the flexibility provided by options.
The most common real options are:
 The
option to expand the project at a later date.
 The option to abandon the project.
 The option to change how the project will
operate and/or what it will produce.
 The option to delay implementation.
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25-35
Spotting the Option
• Options

on Financial Assets
When companies issue securities, they
often include an option in the package.
 Warrants

The right to buy shares from a company at
a stipulated price before a specified date.
 Convertible

The right to exchange the security for
another security, usually common shares.
 Callable

Security
Bond
The right of the issuer to repurchase the
bond before maturity.
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25-36
Summary of Chapter 25

There are two types of options:
 Call
options confer the right to buy an asset for a
specific exercise price on or before a specified
date.
 Put options confer the right to sell an asset for a
specific exercise price on or before a specified
date.



The payoff to buying a call is the maximum of
the stock price minus the exercise price or zero.
The payoff to buying a put is the maximum of
the exercise price minus the stock price or zero.
The payoff to the seller of an option is the mirror
image of the the payoff to the option buyer.
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25-37
Summary of Chapter 25
If the following increase:
STOCK PRICE
The value of a call will:
INCREASE
EXERCISE PRICE
DECREASE
INTEREST RATE
INCREASE
TIME TO EXPIRY
INCREASE
VOLATILITY OF THE
STOCK PRICE
INCREASE
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25-38
Summary of Chapter 25




Options may be present in capital investment
projects.
Such options add value to the project and
include the right to expand, abandon or delay
implementation of the project.
Options may also be present in security issue.
Such options include warrants, convertible
securities and the right of the issuer to call a
security.
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