Fundamentals of Corporate Finance Chapter 23 Options Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Topics Covered Calls and Puts What Determines Option Values Spotting the Option McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Terminology Call Option Right to buy an asset at a specified exercise price on or before the exercise date Put Option Right to sell an asset at a specified exercise price on or before the exercise date McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Obligations Buyer Seller Call option Right to buy asset Obligation to sell asset Put option Right to sell asset Obligation to buy asset McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Value The value of an option at expiration is a function of the stock price and the exercise price Example - Option values given a exercise price of $180 Stock Price Call Value Put Value McGraw-Hill/Irwin $140 40 160 20 180 0 200 20 220 40 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Value Call option value Call option value (graphic) given a $180 exercise price $40 180 220 Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Value Put option value Put option value (graphic) given a $180 exercise price $40 140 180 Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Value Call option $ payoff Call option payoff (to seller) given a $180 exercise price 180 Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- Option Value Put option $ payoff Put option payoff (to seller) given a $180 exercise price 180 Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 10 Option Value Protective Put - Long stock and long put Long Stock Position Value Protective Put Long Put Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 11 Option Value Protective Put - Long stock and long put Position Value Protective Put Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 12 Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Position Value Long put Long call Straddle Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 13 Option Value Position Value Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Share Price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 14 Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or which ever is higher McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 15 Option Value Components of the Option Price - Underlying stock price - Striking or Exercise price - Volatility of the stock returns (standard deviation of annual returns) - Time to option expiration - Time value of money (discount rate) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 16 Option Value Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 17 Options on Real Assets Real Options - Options embedded in real assets McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 18 Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 23- 19 Options on Financial Assets Warrants - Right to buy shares from a company at a stipulated price before a set date Convertible Bond - Bond that the holder may exchange for a specific number of shares Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights [...]... or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 16 Option Value Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights... long put - Strategy for profiting from high volatility Straddle Share Price McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 14 Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 which ever is higher McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 15 Option Value Components of the Option Price 1 -... Long stock and long put Position Value Protective Put Share Price McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 12 Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Position Value Long put Long call Straddle Share Price McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 13 Option Value Position... rights 23- 17 Options on Real Assets Real Options - Options embedded in real assets McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 18 Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 23- 19 Options on Financial Assets Warrants -... a company at a stipulated price before a set date Convertible Bond - Bond that the holder may exchange for a specific number of shares Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights