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Chapter 24Fundamentals of
Corporate FinanceFourth Edition
Options
Slides by
Matthew Will
Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Topics Covered
Calls and PutsWhat Determines Option ValuesSpotting the Option
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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.
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Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
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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 $55
000101520ValuePut
20100000Value Call
7565554540$35PriceStock
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Option Value
Call option value (graphic) given a $55 exercise price.
Share Price
Cal
l opt
ion
valu
e
55 65
$10
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Option Value
Put option value (graphic) given a $55 exercise price.
Share Price
Put
opt
ion
valu
e
45 55
$10
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Option Value
Call option payoff (to seller) given a $55 exercise price.
Share Price
Cal
l opt
ion
$ pa
yoff
55
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Option Value
Put option payoff (to seller) given a $55 exercise price.
Share Price
Put
opt
ion
$ pa
yoff
55
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Option Value
Components of the Option Price1 - 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)
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Option Value
Black-Scholes Option Pricing ModelBlack-Scholes Option Pricing Model
OC = Ps[N(d1)] - S[N(d2)]e-rt
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WSJ Options (9/29/03)
How to Value a Call Option
OPTION
AMD
STRIKE EXP CALL
VOL
CALL
LAST
PUT
VOL
PUT
LAST
10.87 11 Oct 12514 0.75 4658 0.85
10.87 11 Jan 3390 1.65 30 1.60
10.87 12.5 Jan 3544 1.1 5 2.45
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Options on Real Assets
Real Options - Options embedded in real assets
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Options on Real Assets
Real Options - Options embedded in real assets
Option to Expand
Option to Abandon
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Option to Expand
Technique Start Pilot Project Plan to invest if pilot project is successful
Example: Pilot project involves the LEGAL sale and distribution of a new software enabling copying of copyright protected music and video CD’s
Initial Investment for Pilot = $200,000PV of Anticipated Profits over 1 year: = $150,000What is NPV? But provides an option to expand if successful. In
particular
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Project Expansion
Initial Investment $8 millionPV of Anticipated Cash Flow = 40 times pilot
project Cash Flows (PV) + $1 millionThat is present value is: 40*150,000 + 1 = $7
millionShould you undertake the project?Returns on Pilot Project has a standard
deviation of $25,000 so standard deviation of the Full blown project is ~~ $200,000 = .20
Should the Project be undertaken?
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Financials
NPV of full-blown option?
But Note that if the project ends up generating cash flow of more than $8 million we get a positive NPV, but if less we get zero. That is, do not invest the $8 million. What is the value of this option?
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Option Value Exercise price = $8 millionCurrent “Price” = $7 million
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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.
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Calculate the Option value
Go to http://www.numa.com
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Web Resources
www.cboe.com
http://finance.yahoo.com
www.fintools.net/options/optcalc.html
www.optionscentral.com
www.pcquote.com/options
www.pmpublishing.com
www.schaffersresearch.com/stock/calculator.asp
Click to access web sitesClick to access web sites
Internet connection requiredInternet connection required
