FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTEREIGHTEENOptions

Learning Objectives 1. Explain the difference between a call option and a put option. 2. Identify four advantages of options. 3. Describe how options can be used to hedge a portfolio. 4. Describe the factors that affect option prices. 5. Discuss the five aspects of the Black-Scholes option-pricing model.

Introduction Various types of options and related financial instruments have emerged as tools financial managers use to control their firms risk exposure Various types of options and related financial instruments have emerged as tools financial managers use to control their firms risk exposure Derivative securities – derive their value from the value of an underlying asset Derivative securities – derive their value from the value of an underlying asset Options – contracts that grant the holder the right to buy or sell a particular asset at a given price on or before a specified date Options – contracts that grant the holder the right to buy or sell a particular asset at a given price on or before a specified date

General Concepts An option usually contains the following elements: An option usually contains the following elements: 1. The right to buy or sell a security Call options – grants the right to buy Call options – grants the right to buy Put options – grants the right to sell Put options – grants the right to sell 2. A specified price at which the option can be exercised known as the strike or exercise price 3. Limited time frame Expiration date – the date at which an unexercised option becomes void Expiration date – the date at which an unexercised option becomes void

General Concepts Two types of equity options: Two types of equity options: American options – exercisable any time up to or on the expiration date American options – exercisable any time up to or on the expiration date European options – exercised only on expiration date European options – exercised only on expiration date Options trade on organized exchanges or in the OTC market Options trade on organized exchanges or in the OTC market The majority of options are traded on: The majority of options are traded on: Montreal exchange (Canada) Montreal exchange (Canada) American exchange and CBOT (US) American exchange and CBOT (US)

General Concepts Clearing houses are used to maintain the integrity of the option markets Clearing houses are used to maintain the integrity of the option markets CDCC (Canada) CDCC (Canada) DCC (US) DCC (US) US option markets are approximately 40 times larger than Canada’s US option markets are approximately 40 times larger than Canada’s Stock options for any given month expire the third Friday of every month Stock options for any given month expire the third Friday of every month

General Concepts Writing options: Writing options: generally, the options investors buy are written by other investors generally, the options investors buy are written by other investors Leverage: Leverage: options are popular because of the high return potential, but there is downside magnification that must be consider options are popular because of the high return potential, but there is downside magnification that must be consider Hedging: Hedging: options are good for managing corporate risk options are good for managing corporate risk Example: locking in prices for raw commodities Example: locking in prices for raw commodities

Basic Option Characteristics Terminology describing the relationship between the exercise price of the option and current stock price includes: Terminology describing the relationship between the exercise price of the option and current stock price includes: In the money – When the price of the stock (S) exceeds the exercise price of a call (E) In the money – When the price of the stock (S) exceeds the exercise price of a call (E) Out of the money – when the stock price (S) is less than the exercise price (E) Out of the money – when the stock price (S) is less than the exercise price (E) At the money – when the exercise price (E) equals the stock price (S) At the money – when the exercise price (E) equals the stock price (S)

Intrinsic Values Intrinsic value – an options’ minimum value Intrinsic value – an options’ minimum value If a call is “in the money”, it has an immediate intrinsic value equal to the difference between the market price of the stock and the exercise value of the option If a call is “in the money”, it has an immediate intrinsic value equal to the difference between the market price of the stock and the exercise value of the option Intrinsic value of a call = Maximum {(S 0 - E), 0} Intrinsic value of a call = Maximum {(S 0 - E), 0} Puts work in reverse Puts work in reverse Intrinsic value of a put = Maximum {(E - S 0 ), 0} Intrinsic value of a put = Maximum {(E - S 0 ), 0}

Payoffs From Basic Option Positions To understand the characteristics of options we examine their value at expiration To understand the characteristics of options we examine their value at expiration S T = the value of the stock at expiration date T E = the exercise price of the option E = the exercise price of the option Buying a call Buying a call Pay off to a call buyer at expiration = S T - E if S t > E = S T - E if S t > E = 0 if S T  E = 0 if S T  E

Payoffs From Basic Option Positions Payoff Profiles for Call and Put Options at Expiration

BCE Inc. Call Option Example BCE Inc. Nov. call with exercise price of $30 is selling for $5.75 BCE stock at expiration $ Call value at expiration $ If at expiration BCE stock is trading at $40 then: Net profit = option payoff - option cost = $10 - $5.75 = $4.25 = $10 - $5.75 = $4.25 Up to $30 the call option investor’s maximum loss is $5.75 The breakeven point for the investor is at $35.75

BCE Inc. Call Option Example Profit and Losses to the Buyer of a Call Option

Selling (Writing) a Call A naked or uncovered option writer is one who does not hold a position in the underlying asset A naked or uncovered option writer is one who does not hold a position in the underlying asset Naked call option writers incur losses if the stock price increases Naked call option writers incur losses if the stock price increases Payoff to naked call writer at expiration = -(S T - E) if S T  E = -(S T - E) if S T  E = 0 if S T  E = 0 if S T  E The net profit line for a naked call writer is a mirror image of a call buyer The net profit line for a naked call writer is a mirror image of a call buyer

Selling (Writing) a Call Profit and Losses to the Writer of a Call Option

Buying a Put Option n Put option makes money when stock price declines Payoff to put buyer Payoff to put buyer = 0 if S T  E = 0 if S T  E = E - S T if S T  E = E - S T if S T  E

BCE Inc. Put Option Example BCE Inc. Nov. put with exercise price of $30 is selling for $0.30 BCE stock at expiration $ Call value at expiration $ If at expiration BCE stock is trading at $20 then: Net profit = option payoff - option cost = $10 - $0.30 = $9.70 = $10 - $0.30 = $9.70 The breakeven point for the investor is at $29.70

BCE Inc. Put Option Example Profit and Losses to the Buyer of a Put Option

The payoff pattern for a naked put investor is the mirror image of a put buyer The payoff pattern for a naked put investor is the mirror image of a put buyer Payoff to a naked put writer at expiration: Payoff to a naked put writer at expiration: = 0 if S T  E = 0 if S T  E = -(E - S T ) if S T  E = -(E - S T ) if S T  E The writer is obligated to buy the stock at the specified price during the life of the put contract The writer is obligated to buy the stock at the specified price during the life of the put contract If the stock price falls the put buyer may buy the stock and exercise the put by making the writer pay the specified price If the stock price falls the put buyer may buy the stock and exercise the put by making the writer pay the specified price Selling (Writing) a Put

Profit and Losses to the Writer of a Put Option

Protective Puts Involves buying stock and a put option for the same company Involves buying stock and a put option for the same company The put acts as insurance against a decline in the underlying stock price to limit losses The put acts as insurance against a decline in the underlying stock price to limit losses Profit is infinite but reduced by the amount by the cost of the put option Profit is infinite but reduced by the amount by the cost of the put option

Protective Puts The payoff profile: The payoff profile: Payoff of stock S T  E S T  E Payoff of stock S T  E S T  E S T S T S T S T + Payoff of put E - S T 0 E S T E S T

Protective Puts Payoff Profile and Profit/Losses for a Protective Put Position

Covered Calls Covered call – involves buying a stock and the simultaneous sale (or writing) of a call on that stock Covered call – involves buying a stock and the simultaneous sale (or writing) of a call on that stock The position is covered because the writer owns the stock and it could be delivered if called The position is covered because the writer owns the stock and it could be delivered if called The gains are limited if the stock rises, in exchange for cushioning the loss by the amount of the call premium if the stock declines The gains are limited if the stock rises, in exchange for cushioning the loss by the amount of the call premium if the stock declines

Covered Calls The payoff profile: Payoff of stock S T  E S T  E Payoff of stock S T  E S T  E S T S T S T S T + Payoff of put E - S T 0 + Payoff of put E - S T 0 E S T E S T

Covered Calls Payoff Profiles for a Covered Call Position

Option Valuation Option premiums almost never fall below their intrinsic value because of arbitrageurs Option premiums almost never fall below their intrinsic value because of arbitrageurs Arbitrageurs – seek to earn profits without assuming risk by constructing riskless hedges Arbitrageurs – seek to earn profits without assuming risk by constructing riskless hedges Options almost always exceed intrinsic value due to the time value Options almost always exceed intrinsic value due to the time value

Factors Affecting Option Prices Profit and Losses to the Writer of a Call Option

Summary 1. An option is a contract. It either grants the holder the right to purchase (call option) or to sell (put option) a given asset at a particular price for a specified time period. 2. Buyers of calls expect the underlying stock to perform in the opposite direction from the expectations of buyers. 3. Although options have a value, it is a net zero transaction – what the holder gains, the other loses.

Summary 4. Options provide investors with opportunity to create leverage, to know their maximum loss in advance, and to expand their investment opportunity set.

Summary 5. Option prices are affected by: l underlying stock price l exercise price l time expiration l underlying stock volatility l interest rates l and cash dividends paid on the underlying assets