Chapter 21 Principles PrinciplesofCorporateFinance Ninth Edition Understanding Options Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

21- 2 Topics Covered  Calls, Puts and Shares  Financial Alchemy with Options  What Determines Option Values?

21- 3 Option Terminology Put Option Right to sell an asset at a specified exercise price on or before the exercise date. Call Option Right to buy an asset at a specified exercise price on or before the exercise date.

21- 4 Option Obligations

21- 5 Options Terminology Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.) Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time. Call Option - The right to buy a security at a specified price within a specified time. Put Option - The right to sell a security at a specified price within a specified time. Option Premium - The price paid for the option, above the price of the underlying security. Intrinsic Value - Diff between the strike price and the stock price Time Premium - Value of option above the intrinsic value

21- 6 Options Terminology Exercise Price - (Striking Price) The price at which you buy or sell the security. Expiration Date - The last date on which the option can be exercised. American Option - Can be exercised at any time prior to and including the expiration date. European Option - Can be exercised only on the expiration date. All options “usually” act like European options because you make more money if you sell the option before expiration (vs. exercising it). 3 vs =2

21- 7 Genentech Stock Selected prices for puts and calls September 2006

21- 8 Option Value  The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given a exercise price of $80

21- 9 Option Value Call option value (graphic) given a $80 exercise price. Share Price Call option value $15

Option Value Put option value (graphic) given a $80 exercise price. Share Price Put option value $10

Option Value Call option payoff (to seller) given a $80 exercise price. Share Price Call option $ payoff 80

Option Value Put option payoff (to seller) given a $80 exercise price. Share Price Put option $ payoff 80

Option Value Call buyer profit – assume strike of $80 and option price of $9.00 Share Price Position Value Long call Break even

Option Value Put seller profit – assume strike of $80 and option price of $4.60 Share Price Position Value Short put Break even

Option Value Masochists Strategy?- Long stock and short call Share Price Position Value “Silly Strategy” Short Call Long Stock

Option Value Protective Put - Long stock and long put Share Price Position Value Protective Put Long Put Long Stock

Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Share Price Position Value Straddle Long put Long call

Option Value Components of the Option Price 1 - Underlying stock price = Ps 2 - Striking or Exercise price = S 3 - Volatility of the stock returns (standard deviation of annual returns) = v 4 - Time to option expiration = t = days/ Time value of money (discount rate) = r 6 - PV of Dividends = D = (div) e -rt

Time Decay Chart Option Price Stock Price Option prices decline, ceribus paribus, when the time to expiration declines. 90 days to expiration 60 days to expiration 30 days to expiration

Option Value Upper Limit Stock Price Lower Limit (Stock price - exercise price) or 0 which ever is higher

Option Value The value of an option is bound, on the high end, by the value of the underlying stock. The lower bound is the value of exercising the option. In between, the major determinants are exercise price and stock price.

Option Value The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceribus paribus.

Option Value Similar to time decay, the value of an option will be higher when more volatility exists.

Web Resources www. pcquote.com/ Click to access web sites Internet connection required