© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Options and Corporate Securities Chapter Twenty-Five Prepared by Anne Inglis, Ryerson University

25.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Understand the options terminology Be able to determine option payoffs and pricing bounds Understand the five major determinants of option value

25.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Options: The Basics Fundamentals of Option Valuation Valuing a Call Option Equity as a Call Option on the Firm’s Assets

25.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Terminology 25.1 Call Put Strike or Exercise price Expiration date Option premium Option writer American Option European Option

25.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Stock Option Quotations Look at Figure 25.1 in the book –Price and volume information for calls and puts with the same strike and expiration Things to notice –Prices are higher for options with the same strike price but longer expirations –Call options with strikes less than the current price are worth more than the corresponding puts –Call options with strikes greater than the current price are worth less than the corresponding puts

25.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Payoffs – Calls 25.2 The value of the call at expiration is the intrinsic value –C 1 = Max(0, S 1 - E) –If S 1 <E, then the payoff is 0 –If S 1 >E, then the payoff is S 1 – E Assume that the exercise price is $35

25.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Option Payoffs - Puts The value of a put at expiration is the intrinsic value –P 1 = Max (0, E – S 1 ) –If S 1 <E, then the payoff is E-S 1 –If S 1 >E, then the payoff is 0 Assume that the exercise price is $35

25.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Work the Web Example Where can we find option prices? On the Internet, of course. One site that provides option prices is Yahoo Finance Click on the web surfer to go to Yahoo Finance –Enter a ticker symbol to get a basic quote –Follow the options link –Check out “symbology” to see how the ticker symbols are formed

25.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Call Option Bounds Upper bound –Call price must be less than or equal to the stock price Lower bound –Call price must be greater than or equal to the stock price minus the exercise price or zero, whichever is greater If either of these bounds are violated, there is an arbitrage opportunity

25.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 25.3 – Value of a call option before expiration

25.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. A Simple Model An option is “in-the-money” if the payoff is greater than zero If a call option is sure to finish in-the-money, the option value would be –C 0 = S 0 – PV(E) If the call is worth something other than this, then there is an arbitrage opportunity

25.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What Determines Option Values? Stock price –As the stock price increases, the call price increases and the put price decreases Exercise price –As the exercise price increases, the call price decreases and the put price increases Time to expiration –Generally, as the time to expiration increases both the call and the put prices increase Risk-free rate –As the risk-free rate increases, the call price increases and the put price decreases

25.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What about Variance? 25.3 When an option may finish out-of-the-money (expire without being exercised), there is another factor that helps determine price The variance in underlying asset returns is a less obvious, but important, determinant of option values The greater the variance, the more the call and the put are worth –If an option finishes out-of-the-money, the most you can lose is your premium, no matter how far out it is –The more an option is in-the-money, the greater the gain –You gain from volatility on the upside, but don’t lose anymore from volatility on the downside

25.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 25.1 – Five factors that determine option values

25.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Equity: A Call Option 25.5 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 comes due, the option will be exercised and the stockholders retain ownership If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders