18 Chapter Options Slides Developed by: Terry Fegarty Seneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 18 – Outline (1) Options in General  Options  Important Option Features  Types of Options  Stock Options  Call Options  The Option Writer  Intrinsic Value  Options and Leverage  Options that Expire  Trading in Options

© 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 18 – Outline (2)  Writing Options  Put Options  Variables Affecting Option Value  Employee Stock Options  The Executive Stock Option Problem Warrants Convertible Bonds  Advantages of Convertible Bonds  Forced Conversion  Valuation of (Pricing) Convertibles  Effect on Earnings Per Share—Diluted EPS

© 2006 by Nelson, a division of Thomson Canada Limited 4 Options An option gives the option holder a temporary right, to buy (or sell) an asset from (or to) another party at a fixed price

© 2006 by Nelson, a division of Thomson Canada Limited 5 Important Option Features The cost to purchase an option is known as the option premium All options must be sold or exercised prior to their expiry date, or they become worthless Price at which asset is bought/sold under option contract is exercise price or strike price To buyer, the option represents the right, not the obligation to take an action The option writer ( creator) has obligation to perform if buyer decides to exercise option

© 2006 by Nelson, a division of Thomson Canada Limited 6 Stock Options Stock options are purchased:  To speculate on share price movements  To limit losses on share portfolio (hedging) Stock options are securities and can be traded in secondary financial markets Call option (call)—an option to buy a stock Put option (put)—an option to sell stock Options are known as derivatives—derive value from the price of underlying shares Provide speculative leverage. Return on option can be many times larger than return on shares

© 2006 by Nelson, a division of Thomson Canada Limited 7 Types of Options Call Option Right to buy an asset at a fixed price for a fixed period of time Put Option Right to sell an asset at a fixed price for a fixed period of time

© 2006 by Nelson, a division of Thomson Canada Limited 8 Call Options Gives owner right to buy shares at the exercise or strike price for a specified time period Usually 3, 6 or 9 months Option premium (cost) is much less than the price of the underlying shares

© 2006 by Nelson, a division of Thomson Canada Limited 9 Figure 18:1 Basic Call Option Concepts If the option is selling for $1 and the share’s price increased to $63 the option could be exercised and the share immediately sold, resulting in a profit of $3 less the price of the option contract (a $2 profit on a $1 investment, or a 200% return). If the share price doesn’t exceed $60 before the option expires, the $1 is lost (a 100% loss).

© 2006 by Nelson, a division of Thomson Canada Limited 10 Call Options Assume that, three months ago, you could have bought a share for $60, or a call option on the share for $1 Market price 3 months later Profit/loss on call option Profit/loss on owning the share $59-$1-100%-$1-$1.67% $60-$1-100%$00% $61$00%$1+1.67% $62+$1+100%+$2+3.33% $63=$2+200%+$3+5.00%

© 2006 by Nelson, a division of Thomson Canada Limited 11 Call Options Call options are more attractive:  The more volatile the share’s price  The longer the time until expiration Share’s price is more likely to exceed strike price before call option expires In each case, the option premium will be higher

© 2006 by Nelson, a division of Thomson Canada Limited 12 The Option Writer Option writer— person who creates option contract  Agrees to sell shares at strike price if option is exercised Must stand ready to deliver on option contract regardless of how many times option is sold Call writer hopes share price will remain same or drop

© 2006 by Nelson, a division of Thomson Canada Limited 13 Intrinsic Value An option’s intrinsic value is difference between the underlying share’s current price and option’s strike price If current share price is above strike price, call option is in the money  Intrinsic value is difference If current share price is below strike price, call option is out of the money  If option is out of the money, intrinsic value is zero

© 2006 by Nelson, a division of Thomson Canada Limited 14 Intrinsic Value Option will always sell for intrinsic value or above  Minimum intrinsic value = 0  Difference between option’s intrinsic value and price is known as time premium  Investors will pay premium over intrinsic value for chance of profit if share price goes higher (call option)

© 2006 by Nelson, a division of Thomson Canada Limited 15 Figure 18.2: The Value of a Call Option

© 2006 by Nelson, a division of Thomson Canada Limited 16 Options and Leverage Option has tremendous power to multiply return on investment Improves positive returns and worsens negative returns Options offer leveraging potential due to lower price at which you can buy option compared to price of underlying shares  The higher the price of option, the less the leverage potential

© 2006 by Nelson, a division of Thomson Canada Limited 17 Options that Expire Option investing is risky because options expire after a limited time If underlying share price does not rise after call option is purchased, option holder loses some or all of investment As the expiration date approaches, option’s time value approaches zero

© 2006 by Nelson, a division of Thomson Canada Limited 18 Trading in Options Options can be bought and sold at any time prior to expiration  On Montreal Exchange in Canada and on Chicago Board Options Exchange (CBOE) in US  As price of underlying share changes, price of option changes by a greater % Due to lower price of option compared to share Options are rarely exercised before expiration  If call option owner believes share is unlikely to increase further, she is likely to sell option rather than exercise it Would lose any time premium if exercised the option

© 2006 by Nelson, a division of Thomson Canada Limited 19 Writing Options People write options for premium income, hoping that option will never be exercised Option writers lose whatever option buyers win  Take opposite side of a bet Covered option—writer owns underlying shares Naked option—writer does not own underlying shares and must purchase them at current price if option is exercised

© 2006 by Nelson, a division of Thomson Canada Limited 20 Example 18.1: Call Options The following information refers to a three-month call option on the shares of Oxbow, Inc. Price of the underlying share: $30 Strike price of the three-month call: $25 Market price of the option: $8 Q:What is the intrinsic value of the option? A:The intrinsic value represents by how much the option is in the money. Since the share price is $30 and the call option’s strike price is $25, the option is in the money by $5, which is the intrinsic value. Q: What is the option’s time premium at this price? A: The time premium represents the difference between the market price of the option and the intrinsic value, or $8 - $5 = $3. Example

© 2006 by Nelson, a division of Thomson Canada Limited 21 Example 18.1: Call Options Q:If an investor writes and sells a covered call option, acquiring the covering share now, how much has he invested? A:The premium ($8) that the writer receives for the option will offset some of the purchase price of the share ($30), therefore the investor has invested $30 - $8 = $22. Q: What is the most the buyer of the call can lose? A:The buyer can lose, at most, 100% of his investment which is the purchase price of the option of $8. Q:What is the most the writer of a naked call option on this share can lose? A:In theory since the share price can rise to any price the writer can lose an infinite amount. However, a prudent writer would limit her losses by purchasing the share once it started to rise in value. Example

© 2006 by Nelson, a division of Thomson Canada Limited 22 Example 18.1: Call Options Just before the option’s expiration Oxbow is selling for $32. Q: What is the profit or loss from buying the call? A:The buyer would exercise the option, paying $25 for the share and simultaneously sell the share for $32, resulting in a gain of $7. However, this gain would be offset by the $8 premium paid for the option, resulting in an overall loss of $1. Q: What is the profit or loss from writing the naked call? A:Call writer would have to buy the share for $32 and sell it to the option owner for $25, resulting in a loss of $7. However, this loss would be offset by the premium received on the writing of the option of $8, resulting in an overall gain of $1. Q:What is the profit or loss from writing the covered call if the covering share was acquired at the time the call was written? A:The call writer bought the share for $30 and sold it for $25, resulting in a loss of $5, but the loss is offset by the $8 premium received for writing the option. The overall gain is $3. Example

© 2006 by Nelson, a division of Thomson Canada Limited 23 Put Options An option to sell underlying asset (share) at a specified price by a specified date Would buy a put if you thought the price of the underlying asset going to fall Put option is in the money if the strike price is lower than the current share price Intrinsic value—how much the option is in the money Guarantees the minimum price the share could be sold for

© 2006 by Nelson, a division of Thomson Canada Limited 24 Figure 18.3: Basic Put Option Concepts

© 2006 by Nelson, a division of Thomson Canada Limited 25 Figure 18.4: The Value of a Put Option

© 2006 by Nelson, a division of Thomson Canada Limited 26 Table 18.1: Typical Quotes

© 2006 by Nelson, a division of Thomson Canada Limited 27 Variables Affecting Option Value Variables affecting the value of an option Share Price Expiration Date Price Volatility Risk-free Interest Rate Exercise Price

© 2006 by Nelson, a division of Thomson Canada Limited 28 Variables Affecting Option Value Increase to Variable:Effect on Call Option Prices Effect on Put Option Prices Share Price  Exercise Price  Volatility  Risk-free interest rate  Expiration date 

© 2006 by Nelson, a division of Thomson Canada Limited 29 Employee Stock Options Given to certain employees as part of compensation  Generally receive lower salary than they would otherwise If a company is expected to have good future, employees may want to receive options Companies like paying with options because they can pay employees lower salary  Argue that options allow up-and-coming companies to attract talented employees they couldn’t otherwise afford

© 2006 by Nelson, a division of Thomson Canada Limited 30 The Executive Stock Option Problem Senior executives usually receive the most stock options Tactic has been criticized recently  May cause executives to try to increase share price by manipulating financial results One result of recent overhaul of financial reporting is requirement that companies report employee stock options as expenses when issued  Problem is that no one knows how high the shares will rise in value after options are issued

© 2006 by Nelson, a division of Thomson Canada Limited 31 Warrants Warrants are issued by underlying companies  When warrant is exercised company issues new shares and receives exercise price Warrants are primary market instruments while options are secondary market instruments

© 2006 by Nelson, a division of Thomson Canada Limited 32 Warrants Similar to call options but  have longer expiration period (several years vs. months)  strike price set well above current market price of shares Usually issued as a “sweetener” (for bonds, for instance) Can generally be detached from another issue and sold separately

© 2006 by Nelson, a division of Thomson Canada Limited 33 Convertible Bonds Unsecured bonds exchangeable for fixed number of shares of company at bondholder's discretion  Allows bondholders to participate in a share’s price appreciation should the firm be successful Conversion ratio—number of shares that will be received for each bond Conversion price—implied share price if bond is converted into certain number of shares  Usually set 15-30% higher than share’s market value at time bond is issued Can usually be issued at lower coupon rates

© 2006 by Nelson, a division of Thomson Canada Limited 34 Example 18.2: Convertible Bonds Q. Dean Neri purchased one of Algo Corp’s 9%, 25 year convertible bonds at its $1,000 par value a year ago, when the company’s common shares were selling for $20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into shares at a price of $25. The shares are now selling for $29. Algo pays no dividends. a. Dean exercised the conversion feature today and immediately sold the shares he received. Calculate the total return on his investment. b. What would Dean’s return have been if he had invested $1,000 in Algo’s shares instead of the bond? c. Comment on the difference between the returns in parts (a) and (b), and from investing in a nonconvertible bond. d. Would the convertible have been a good investment if the share price had fallen? Example

© 2006 by Nelson, a division of Thomson Canada Limited 35 Example 18.2: Convertible Bonds A: a. Number of shares exchanged for bond: ($1,000 / $25 =) 40 shares Proceeds of selling shares at current market price: (40 x $29 =) $1,160 Bond paid interest during the year: ($1,000 x.09 =) $90 Total receipts from the bond investment: ($1,160 + $90 =) $1,250 The bond cost $1,000, so his gain is ($1,250 - $1,000 =) $250 Return on investment ($250 / $1,000 =) 25% b. If Dean had invested $1,000 in Algo’s shares, he would have purchased (1,000 / $20 =) 50 shares Increase in share value: ($29 - $20 =) $9 Total gain: (50 x $9 =) $450 Return would have been ($450 / $1,000 =) 45% Example

© 2006 by Nelson, a division of Thomson Canada Limited 36 Example 18.2: Convertible Bonds A: c. Investing in ordinary bonds would have returned 12%. Investing in Algo shares would returned 45%. The convertible, at 25%, allowed bond investors to participate in some, but not all, of the unusually high return enjoyed by share investors. d. Convertibles limit risk relative to investing in shares. Had Algo’s shares price fallen, an investment in it would have generated a negative return. But Dean’s return would have been the convertible’s 9% coupon rate. That’s less than the 12% offered by ordinary debt, but substantially better than a loss. Example

© 2006 by Nelson, a division of Thomson Canada Limited 37 Convertible Bonds The effect of conversion on financial statements and cash flow  Upon conversion an accounting entry transfers bonds from long-term debt into common shares  No immediate cash flow impact, but ongoing cash flow implications exist Interest payments will stop If shares pay dividend, the newly created shares are entitled to those dividends  Improves debt management ratios

© 2006 by Nelson, a division of Thomson Canada Limited 38 Advantages of Convertible Bonds To issuing companies  Convertible features are sweeteners that let firm pay lower interest rate (coupon)  Can be viewed as way to sell common shares at price above market  Usually have few or no restrictions To buyers  Offer chance to participate in share price appreciation  Offer way to limit risk associated with a share investment

© 2006 by Nelson, a division of Thomson Canada Limited 39 Forced Conversion A firm may want bonds to be converted because  Eliminates interest payments on bond  Strengthens balance sheet Convertible bonds are always issued with call features  Can be used to force conversion Issuers generally call convertibles when share prices rise to 10-15% above conversion price  Rational investors will convert if conversion value is greater than call value

© 2006 by Nelson, a division of Thomson Canada Limited 40 Valuation of (Pricing) Convertibles Convertible’s price can depend on  Value as traditional bond or  Market value of shares into which it can be converted At any share price, convertible is worth at least larger of value as bond or as shares  Market value will be greater due to possibility that share’s price will rise

© 2006 by Nelson, a division of Thomson Canada Limited 41 Figure 18.5 : Value of a Convertible Bond

© 2006 by Nelson, a division of Thomson Canada Limited 42 Example 18.3: Valuation of (Pricing) Convertibles Q: Summarizing from Example 18.2, Algo’s convertible bond was issued at its par value of $1,000 for 25 years at a coupon rate of 9%. The market rate was 12%, and the bond was exchangeable into 40 shares. The shares were selling for $20. What was the conversion premium of the Algo convertible at the time it was issued? Example

© 2006 by Nelson, a division of Thomson Canada Limited 43 Example 18.3: Valuation of (Pricing) Convertibles A: Bond equation 9.4: PB = PMT[PVFAk,n] + FV[PVFk,n] PMT = $1,000(.09)/2 = $45, k = 12/2 = 6, FV = $1,000, n = 25 x 2 = 50 The minimum value of the convertible as a bond: = $45[PVFA6,50] + $1,000[PVF6,50] =$45( ) + $1,000(.0543) = $ The conversion ratio is ($1,000 / $25=) 40 The equation of the value as stock line is PB = 40PS The share price at the break in the minimum value line. $ = 40PS PS = $19.09 The market price of the shares was $20, which is higher than the break point. The convertible’s value as shares is the appropriate minimum The bond’s minimum value as shares: PB = 40PS = 40 x $20 = $800 Conversion Premium = Market price – Minimum = $1,000 - $800 = $200 Example

© 2006 by Nelson, a division of Thomson Canada Limited 44 Effect on Earnings Per Share— Diluted EPS Upon conversion, convertible bonds cause dilution in EPS  EPS drops due to increase in number of shares CICA requires that companies report potential dilution in EPS  Diluted EPS adjusts basic EPS for shares added and interest saved (after tax) by potential conversion

© 2006 by Nelson, a division of Thomson Canada Limited 45 Example Q:Montgomery Inc. issued 2,000 convertible bonds in 2001 at a coupon rate of 8% and a par value of $1,000. Each bond is convertible into Montgomery’s common shares at $40 per share. In 2005 Montgomery had net income of $3 million. One million shares were outstanding for the entire year, and the marginal tax rate is 40%. Calculate Montgomery’s basic and diluted EPS. A:Basic EPS is the firm’s net income divided by the number of shares outstanding, or $3,000,000 ÷ 1,000,000 = $3.00. Example 18.4: Effect on Earnings Per Share—Diluted EPS

© 2006 by Nelson, a division of Thomson Canada Limited 46 Example 18.4: Effect on Earnings Per Share—Diluted EPS Example A : Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made: Add the number of newly converted shares to the denominator: Shares exchanged: Bond’s par ÷ Conversion price = $1,000 ÷ $25 = 40 The newly converted shares total (40 x 2,000 =) 80,000 The total number of shares outstanding =1,080,000.

© 2006 by Nelson, a division of Thomson Canada Limited 47 Example 18.4 : Effect on Earnings Per Share—Diluted EPS Adjust the net income figure in the numerator by the amount of interest saved: The 2,000 bonds pay 8% interest on a $1,000 par; therefore the firm will save (.08 x $1,000 x 2,000 =) $160,000 in interest However, the interest expense was tax deductible, so the firm’s taxable income will now rise by $160,000, resulting in an increase in taxes of ($160,000 x 0.40 =) $64,000 Thus the firm’s Net Income will rise by $96,000 resulting in a new Net Income of $3,096,000. The firm’s diluted EPS will be ($3,096,000 ÷ 1,080,000 =) $2.87. Example