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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared.

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Presentation on theme: "Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared."— Presentation transcript:

1 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-1 Chapter Twenty-one Options, Corporate Securities and Futures

2 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Options: The Basics 21.2Fundamentals of Options Valuation 21.3Valuing a Call Option 21.4Black–Scholes Option Pricing Model 21.5Equity as a Call Option on the Firms Assets 21.6Types of Equity Option Contracts 21.7 Futures Contracts 21.8Term Structure of Interest Rates 21.9Summary and Conclusions Chapter Organisation

3 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-3 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.

4 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-4 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.

5 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-5 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.

6 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-6 Option Contract Characteristics Expiration month Option type Contract size Expiry Exercise price

7 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-7 Option Valuation S 1 = share price at expiration S 0 = share price today C 1 = value of call option on expiration C 0 = value of call option today E = exercise price on the option

8 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-8 Share price at expiration (S 1 ) Call option value at expiration (C 1 ) S 1 E S 1 > E Exercise price (E) 45 ° Value of Call Option at Expiration

9 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 21-9 Value of Call Option at Expiration Option is out of the money. Option is in the money.

10 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Share price (S 0 ) Call price (C 0 ) Exercise price (E) 45 ° Lower bound C 0 S 0 – E C 0 0 Upper bound C 0 S 0 Value of a Call Option Before Expiration

11 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Call Option Boundaries Upper bounda call option will never be worth more than the share itself: C 0 S 0 Lower boundshare price cannot fall below 0 and to prevent arbitrage, the call value must be (S 0 – E): The larger of 0 or (S 0 – E) Intrinsic valueoptions value if it was about to expire = lower bound.

12 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Factors Determining Option Values The value of a call option depends on four factors: share price exercise price time to expiration risk-free rate.

13 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Another Factor to Consider? The above four factors are relevant if the option is to finish in the money. If the option can finish out of the money, another factor to consider is volatility. The greater the volatility in the underlying share price, the greater the chance the option has of expiring in the money.

14 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright The Factors that Determine Option Value

15 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Black–Scholes Option Pricing Model

16 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Black–Scholes Option Pricing Model Note: The risk-free rate, the standard deviation and the time to maturity must all be quoted using the same time units.

17 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright ExampleBlack–Scholes Option Pricing Model S 0 = $25 E = $20 R f = 8% = 30% t = 0.5 years

18 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright ExampleBlack–Scholes Option Pricing Model (continued)

19 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright ExampleBlack–Scholes Option Pricing Model (continued) From the cumulative normal distribution table: N(d 1 ) = N(1.34) = N(d 2 ) = N(1.13) = Therefore, the value of the call option is:

20 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Equity: A Call Option Equity can be viewed as a call option on the companys 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.

21 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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.

22 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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 warrantslow exercise price warrants fractional warrantsendowment warrants basket warrantscurrency warrants fully covered warrants index warrants instalment warrants

23 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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.

24 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Company Options versus Exchange- traded 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.

25 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Earnings Dilution Put and call options have no effect on the value of the firm. Company options do 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.

26 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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 – Longagrees to buy the asset at the future date – Shortagrees 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.

27 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Forward Contracts A. Buyers perspectiveB. Sellers perspective Payoff profile Payoff profile P oil V V

28 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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.

29 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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.

30 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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: Longan increase in the settlement price leads to a gain Shortan increase in the settlement price leads to a loss Open interest is how many contracts are currently outstanding.

31 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Term Structure of Interest Rates

32 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 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.

33 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright Factors Determining the Term Structure Risk preferencesborrowers prefer long-term credit whereas lenders prefer short-term loans (explains upward-sloping yield curve only). Supply demand conditionssegmented capital markets can cause supply demand imbalances (explains all yield curve shapes). Expectations about future interest rates (most favoured explanation)


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