Fundamentals of corproate finance 3e chapter 21

Chapter Twenty-one Options, Corporate Securities and Futures Copyright  2004 McGraw-Hill Australia Pty Ltd 21-1 Chapter Organisation 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 21.9 Options: The Basics Fundamentals of Options Valuation Valuing a Call Option Black–Scholes Option Pricing Model Equity as a Call Option on the Firm’s Assets Types of Equity Option Contracts Futures Contracts Term Structure of Interest Rates Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 21-2 Chapter Objectives • Understand the key terminology associated with • • • • • • options Outline the five factors that determine option values Price call options using the Black–Scholes option pricing model Discuss the types of equity option contracts offered Outline the types of warrants available to investors Discuss the characteristics of future contracts Understand the term structure of interest rates Copyright  2004 McGraw-Hill Australia Pty Ltd 21-3 Option Terminology • Call option – Right to buy a specified asset at a specified price on or before a specified date • Put option – Right to sell a specified asset at a specified price on or before a specified date • European option – An option that can only be exercised on a particular date (on expiry) • American option – An option that can be exercised at any time up to its expiry date Copyright  2004 McGraw-Hill Australia Pty Ltd 21-4 Option Terminology • Striking price – The contracted price at which the underlying asset can be bought (call) or sold (put) • Expiration date – The date at which an option expires • Option premium – The price paid by the buyer for the right to buy or sell an asset • Exercising the option – The act of buying or selling the underlying asset via the option contract Copyright  2004 McGraw-Hill Australia Pty Ltd 21-5 Option Contract Characteristics • Expiration month • Option type • Contract size • Expiry • Exercise price Copyright  2004 McGraw-Hill Australia Pty Ltd 21-6 Option Valuation • S1 = share price at expiration • S0 = share price today • C1 = value of call option on expiration • C0 = value of call option today • E = exercise price on the option Copyright  2004 McGraw-Hill Australia Pty Ltd 21-7 Value of Call Option at Expiration Call option value at expiration (C1) S1 ≤ E S1 > E 45 ° Exercise price (E) Copyright  2004 McGraw-Hill Australia Pty Ltd Share price at expiration (S1) 21-8 Value of Call Option at Expiration C1 = if ( S1 − E ) ≤ Option is out of the money C1 = S1 − E if ( S1 − E ) > Option is in the money Copyright  2004 McGraw-Hill Australia Pty Ltd 21-9 Value of a Call Option Before Expiration Call price Upper bound Lower bound (C0) C0 ≤ S0 C0 ≥ S0 – E C0 ≥ 45 ° Share price (S0) Exercise price (E) Copyright  2004 McGraw-Hill Australia Pty Ltd 2110 Example—Black–Scholes Option Pricing Model (continued) • From the cumulative normal distribution table: N(d1) = N(1.34) = 0.9099 N(d2) = N(1.13) = 0.8708 • Therefore, the value of the call option is: C0 = 25 ( 0.9099) − 20 ( 08 )( ) e = 22.7475 − 16.7331 ( 0.8708) = $6.01 Copyright  2004 McGraw-Hill Australia Pty Ltd 2119 Equity: A Call Option • Equity can be viewed as a call option on the company’s assets when the firm is leveraged • The exercise price is the value of the debt • If the assets are worth more than the debt when it becomes due, the option will be exercised and the shareholders retain ownership • If the assets are worth less than the debt, the shareholders will let the option expire and the assets will belong to the bondholders Copyright  2004 McGraw-Hill Australia Pty Ltd 2120 Equity Option Contracts • Types of equity option contracts offered in Australia: – Exchange traded put and call options on company shares – Exchange traded long dated contracts issued by a financial institution that can then trade them (warrants) – Over-the-counter options on company shares – Convertible notes issued by companies, comprising both a debt and an equity component Copyright  2004 McGraw-Hill Australia Pty Ltd 2121 Warrants • A long-lived option that gives the holder the right to buy shares in a company at a specified price • Types of warrants available: equity warrants fractional warrants basket warrants fully covered warrants index warrants instalment warrants low exercise price warrants endowment warrants currency warrants Copyright  2004 McGraw-Hill Australia Pty Ltd 2122 Company Options • A holder is given the right to purchase shares in a company at a specified price over a given period of time • Usually offered as a ‘sweetener’ to a debt issue • These options are often detached and sold separately Copyright  2004 McGraw-Hill Australia Pty Ltd 2123 Company Options versus Exchangetraded Options • Company options have longer maturity periods and are often European-type options • Company options are issued as part of a capital- raising program and are therefore limited in number • The clearing house has no role in the trading of company options • Company options are issued by firms Copyright  2004 McGraw-Hill Australia Pty Ltd 2124 Earnings Dilution • Put and call options have no effect on the value of the firm • Company options affect the value of the firm • Company options cause the number of shares on issue to increase when: – – the options are exercised the debts are converted • This increase does not lower the price per share but EPS will fall Copyright  2004 McGraw-Hill Australia Pty Ltd 2125 Forward Contracts • • • • A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date Forward contracts are legally binding on both parties They can be tailored to meet the needs of both parties and can be quite large in size Positions Long—agrees to buy the asset at the future date – Short—agrees to sell the asset at the future date – • Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations Copyright  2004 McGraw-Hill Australia Pty Ltd 2126 Forward Contracts ∆V ∆V Payoff profile ∆Poil ∆Poil Payoff profile A Buyer’s perspective B Seller’s perspective Copyright  2004 McGraw-Hill Australia Pty Ltd 2127 Futures Contracts • An agreement between two parties to exchange a specified asset at a specified price at a specified time in the future • Do not need to own an asset to sell a future contract • Either buy before delivery or close out position with an opposite market position Copyright  2004 McGraw-Hill Australia Pty Ltd 2128 Futures Markets • Enable buyers and sellers to avoid risk in • • • • commodities (and other) markets with high price variability → hedging Involves standardised contracts Deposit required by all traders to guarantee performance Adverse price movements must be covered daily by further deposits called margins (‘marked to market’) Futures also available for short-term interest rates, to protect against interest rate movements Copyright  2004 McGraw-Hill Australia Pty Ltd 2129 Futures Quotes • Commodity, exchange, size, quote units The contract size is important when determining the daily gains and losses for marking-to-market Delivery month – Open price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest – The change in settlement price multiplied by the contract size determines the gain or loss for the day: – •   Long—an increase in the settlement price leads to a gain Short—an increase in the settlement price leads to a loss • Open interest is how many contracts are currently outstanding Copyright  2004 McGraw-Hill Australia Pty Ltd 2130 Term Structure of Interest Rates Copyright  2004 McGraw-Hill Australia Pty Ltd 2131 Term Structure of Interest Rates • Yield curve shows the different interest rates available for investments of different maturities, at a point in time • The relationship between interest rates of different maturities is called the term structure Copyright  2004 McGraw-Hill Australia Pty Ltd 2132 Factors Determining the Term Structure • Risk preferences—borrowers prefer long-term credit whereas lenders prefer short-term loans (explains upward-sloping yield curve only) • Supply−demand conditions—segmented capital markets can cause supply−demand imbalances (explains all yield curve shapes) • Expectations about future interest rates (most favoured explanation) Copyright  2004 McGraw-Hill Australia Pty Ltd 2133 .. .Chapter Organisation 21. 1 21. 2 21. 3 21. 4 21. 5 21. 6 21. 7 21. 8 21. 9 Options: The Basics Fundamentals of Options Valuation Valuing a Call Option Black–Scholes... Discuss the types of equity option contracts offered Outline the types of warrants available to investors Discuss the characteristics of future contracts Understand the term structure of interest rates... exchange of cash initially, they are usually limited to large, creditworthy corporations Copyright  2004 McGraw-Hill Australia Pty Ltd 212 6 Forward Contracts ∆V ∆V Payoff profile ∆Poil ∆Poil Payoff