1. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 18: Options Basics Corporate Finance, 3e Graham, Smart, and Megginson

2. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Economic Benefits Provided by Options 2 Derivative securities are instruments that derive their value from the value of other assets. Derivatives include options, futures, and swaps. Options and other derivative securities have several important economic functions: –Can help align managerial interests with those of shareholders –Help bring about more efficient allocation of risk –Save transactions costs…sometimes it is cheaper to trade a derivative than its underlying asset. –Permit investment strategies that would not otherwise be possible

3. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 3 Call option Gives the holder the right to purchase an asset at a specified price on or before a certain date Put option Gives the holder the right to sell an asset at a specified price on or before a certain date Strike price or exercise price: The price specified for purchase or sale in an option contract American or European option American options allow holders to exercise at any point prior to expiration. European options allow holders to exercise only on the expiration date. Options Vocabulary

4. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Options Trading 4 Long position The buyer of an option has a long position, and has the ability to exercise the option. Short position The seller (or writer) of an option has a short position, and must fulfill the contract if the buyer exercises. As compensation, the seller receives the option premium from the buyer. Options trade on an exchange (such as CBOE) or in the over-the-counter market.

5. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Option Prices 5 CallPut S > XIn the moneyOut of the money S = XAt the money S < XOut of the moneyIn the money S = Current stock price X = Strike price

6. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Intrinsic and Time Value of Options 6 Intrinsic value For in the money options: The difference between the current price of the underlying asset and the strike price For out of the money options, the intrinsic value is zero. Time value The difference between the option’s intrinsic value and its market price (premium)

7. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Payoff Diagrams 7 Show the value of an option, or the value at expiration Y-axis plots exercise value or “intrinsic value.” X-axis plots price of underlying asset. Use payoff diagrams for: Long and short positions Gross and net positions (the net positions subtract the option premium) Payoff: The price of the option at expiration date

8. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Naked Option Positions  Naked call option position – Occurs when an investor buys or sells an option on a stock without having a position in the underlying stock  Naked put option positions – Occurs when a trader buys or sells a put option without having a position in the underlying stock  These positions are purely speculative. 8

9. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Portfolios of Options 9 Look at payoff diagrams for combinations of options rather than just one Diagrams show the range of potential strategies made possible by options. Some positions, in combination with other positions, can be a form of portfolio insurance.

10. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Straddle Positions  Long straddle  A portfolio consisting of long positions in calls and puts on the same stock with the same strike price and expiration date  Short straddle  A portfolio consisting of short positions in calls and puts on the same stock with the same strike price and expiration date 10

11. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Covered Call Strategy  Writing covered calls – Common trading strategy that mixes stock and call options  An investor who owns a share of stock sells a call option on that stock.  The investor receives the option premium immediately.  The trade-off is that if the stock price rises…  the holder of the call option will exercise the right to purchase it at the strike price, and  the investor will lose the opportunity to benefit from the appreciation in the stock. 11

12. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Put-Call Parity  For this formula to hold, the call and put options must…  be on the same underlying stock,  have the same exercise price,  share the same expiration date, and  be European options.  In addition, the following conditions must hold:  The underlying stock must not pay a dividend during the life of the options.  The bond must be a risk-free, zero-coupon bond with a face value equal to the strike price of the options and with a maturity date identical to the options’ expiration date. 12

13. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Factors Affecting Option Values 13 Price of underlying asset Asset price and call price are positively related. Asset price and put price are negatively related. Time to expiration More time usually makes options more valuable. Strike price Higher X means higher put price; lower X means higher call price. Volatility Options are more valuable when the underlying asset’s price is more volatile.

14. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Binomial Option Pricing  The binomial options model recognizes that investors can combine options (either calls or puts) with shares of the underlying asset to construct a portfolio with a risk-free payoff.  Data needed:  The current price of the underlying stock  The time remaining before the option expires  The strike price of the option  The risk-free rate  The possible values of the underlying stock in the future 14

15. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Risk-Neutral Method  If a combination of stock and options is risk- free, it must earn the same return as a risk- free bond.  If an asset promises a risk-free payoff, risk- averse and risk-neutral investors agree on how it should be valued.  Whether investors are risk averse or risk neutral, the binomial model’s calculations are the same.  We can assume investors are risk neutral, which gives us a new way to value options. 15