Fundamentals of Corporate Finance Chapter 23 Options Fifth

Fundamentals of Corporate Finance Chapter 23 Options Fifth Edition Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 2 Topics Covered ÜCalls and Puts ÜWhat Determines Option Values ÜSpotting the Option Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 4 Option Obligations Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 5 Option Value Ü 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 $180 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 6 Option Value Call option value (graphic) given a $180 exercise price. $40 180 220 Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 7 Option Value Put option value (graphic) given a $180 exercise price. $40 180 Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 8 Option Value Call option $ payoff Call option payoff (to seller) given a $180 exercise price. 180 Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 9 Option Value Put option $ payoff Put option payoff (to seller) given a $180 exercise price. 180 Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 10 Option Value Protective Put - Long stock and long put Long Stock Position Value Protective Put Long Put Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 11 Option Value Protective Put - Long stock and long put Position Value Protective Put Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 12 Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Position Value Long put Long call Straddle Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 13 Option Value Position Value Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Share Price Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 14 Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 which ever is higher Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 15 Option Value Components of the Option Price 1 - Underlying stock price 2 - Striking or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate) Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 16 Option Value Black-Scholes Option Pricing Model OC = Ps[N(d 1)] - S[N(d 2)]e-rt Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 17 Options on Real Assets Real Options - Options embedded in real assets Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 18 Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

23 - 19 Options on Financial Assets Warrants - Right to buy shares from a company at a stipulated price before a set date. Convertible Bond - Bond that the holder may exchange for a specific number of shares. Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved