1. Corporate Finance, Concise Understanding Options
Principles of
Corporate Finance, Concise
Second Edition
Chapter 16
Understanding Options
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 2 1

2. Topics Covered Calls, Puts and Shares Financial Alchemy with Options
What Determines Option Values? 2 2 2 2 3 2

3. Option Terminology Call Option
Right to buy an asset at a specified exercise price on or before the exercise date.
Put Option Right to sell an asset at a specified exercise price on or before the exercise date. 4

4. Option Obligations 5

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 2

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 3

7. Selected prices for puts and calls September 2008
Google Stock
Selected prices for puts and calls September 2008

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 7

9. Option Value
Google Call option value (graphic) given a $430 exercise price.
$430
Call option value
430
Share Price 8

10. Option Value
Google Put option value (graphic) given a $430 exercise price.
$430
Put option value
430
Share Price 9

11. Option Value
Google Call option payoff (to seller) given a $430 exercise price.
Call option $ payoff
$430
430
Share Price 10

12. Option Value
Google Put option payoff (to seller) given a $430 exercise price.
Put option $ payoff
$430
430
Share Price 11

13. Option Value
Call buyer profit – assume strike of $430 and option price of $54.35
Long call
Break even
Position Value
-54.35
Share Price 18

14. Option Value
Put seller profit – assume strike of $430 and option price of $48.55
Break even
Short put
Position Value
+48.55
Share Price 18

15. Option Value Masochists’ Strategy?- Long stock and short call
“Silly Strategy”
Short Call
Position Value
Share Price 14

16. Option Value Protective Put - Long stock and long put Long Stock
Position Value
Long Put
Share Price 14

17. Option Value
Straddle - Long call and long put - Strategy for profiting from high volatility
Long call
Long put
Straddle
Position Value
Share Price 18

18. Financial Alchemy

19. Financial Alchemy

20. Financial Alchemy

21. Financial Alchemy

22. Financial Alchemy

23. 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/365
5 - Time value of money (discount rate) = r
6 - PV of Dividends = D = (div)e-rt

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

25. (Stock price - exercise price) or 0
Option Value
Stock Price
Upper Limit
Lower Limit
(Stock price - exercise price) or 0
which ever is higher 21

26. 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.

27. 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.

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

29. Option Value

30. Option Value

31. Web Resources Click to access web sites Internet connection required