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Introduction to Corporate Finance
Prepared byYing PanTong Niu
Charlie GiurleoI.Murat Coskun
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Introduction
Basic concept - History - Current markets & Regulator - Characteristics & Terminology
Types of Options - Call options - Put options
Valuation - Payoff method - Binomial tree method
Strategies- Bullish strategy- Bearish strategy- Neutral strategy
Q&A & REWARDS!
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House selling at $1M
Option Contract@ $10,000
Seller (Writer) Buyer (Holder)
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House now selling at $2M ()
Seller (Writer) Buyer (Holder)
Scenario #1
Option Contract@ $10,000
$2,000,000$1,000,000 - $10,000 $990,000 (Profit)
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House now selling at $100K ()
Seller (Writer) Buyer (Holder)
Scenario #2
Option Contract@ $10,000
- $10,000 ($10,000) (Loss)
- Ancient Greek philosopher and mathematician – Thales of Miletus
- Purchased the Right to rent numerous olive presses before a predicted increase in olive harvest
- Fortunately, his prediction was right- Exercised his Right to rent out all presses!
HistoryHistory
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- Major markets over the world:
Current Markets & Current Markets & Regulator Regulator
•In Canada, options are traded on the Montreal Exchange and are cleared through the Canadian Derivatives Clearing Corp(CDCC)
•The CDCC stands between option buyers and option sellers (writers).
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Two parties: Seller (also called writer) Buyer (also called holder)
- The seller sells an “Option” contract to the buyer, accepts a premium and assumes the obligation that is specified in the contract
- The buyer pays premium to the seller and gets the “option” or choice or right to buy the underlying asset from the seller during a particular period of time
Option is a contractOption is a contract
CALL PUT
BUYER(Long)
Right to Buy Right to Sell
SELLER(Short)
Obligation to Sell Obligation to BuyOptions
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Call Option (or Calls): the right but not the obligation to buy an underlying asset during a particular period of time
Put Option (or Puts): the right but not the obligation to SELL an underlying asset during a particular period of time
A put option is the opposite of a call option
TerminologyTerminology
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Exercise the option: invoke the rights contracted
Exercising price (or striking price): the price at which the buyer can purchase or sell the underlying instrument
Expiration date: the date at which the rights to exercise the option cease to exist
Option premium: the price of an option
In-the-money, out-of-the-money: making a profit vs. not
TerminologyTerminology
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Trading Platform:- Listed: openly traded in exchange market- Over-the-counter: between two private parties
Exercise Types:- American: the right could be exercised any date before the
expiration date- European: the right could be exercised only on the day of
expiration date
Underlying assets :- Usual assets, common shares, commodities, rare metals,
interest rates, exchange rates, etc.
CharacteristicsCharacteristics
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The buyer speculates the stock price will go up, then buy a call option by paying the option price (premium). If the stock price goes up during the expiration period, the buyer exercises the option and earns the profit. As illustrate in the table, the stock price goes up from $80 to $100, the call option buyer earns $11($20 minus $9 of option price ).
Buying a call from the Buying a call from the Buyer’s perspectiveBuyer’s perspective
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
80 100 July C 9 20 11
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Payoff from the buying a callPayoff from the buying a call
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
80 100 July C 9 20 11
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The seller will get the premium whenever he/she sells a call option. If the stock price does not go up by the expiration, the call buyer will not exercise the option and the seller can get the premium as a net profit.
If the stock price goes up and the buyer exercises the option, then the seller have to assume the obligation to sell the stock with the exercise price and bear a loss which equal is to the buyer’s net profit. In the example above, $11 is seller’s net loss and buyer’s net profit
Selling a call from theSelling a call from theSeller’s perspectiveSeller’s perspective
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
80 100 July C 9 20 11
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Payoff from writing a call.
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
80 100 July C 9 20 11
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The buyer speculates the stock price will go down, then buy a put option by paying the option price (premium). If the stock price goes down by the expiration, the buyer exercises the option and earns the profit. As illustrate in the table, the stock price goes down from $85 to $75, the call option buyer earns $10 minus $5 of option price and get $5 net profit.
Buying a put from the Buying a put from the buyer’s perspectivebuyer’s perspective
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
85 75 Aug P 5 10 5
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Payoff from buying a put.
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
85 75 Aug P 5 10 5
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The seller will get the premium whenever he/she sells a put option. If the stock price does not go down by the expiration, the put buyer will not exercise the option and the seller can get the premium as a net profit.
If the stock price goes down and the buyer exercises the option, then the seller have to assume the obligation to sell the stock with the exercise price and bear a loss which equal to the buyer’s net profit. In the example above, $5 is seller’s net loss and buyer’s net profit
Selling a put from the Selling a put from the seller’s perspectiveseller’s perspective
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
85 75 Aug P 5 10 5
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Payoff from writing a put.
Striking Price
Stock
Price
Expiration
Date
P/C Option Price
Option Value
Net Profit
85 75 Aug P 5 10 5
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Call option value= Stock value - PV of the exercise price
5 key variables:1) Current stock price (S0)
2) Exercise price of the option (E)
3) Time of expiration (t)
4) Risk free rate (Rf)
5) Variance of return on stock
C0=S0 -E/(1+Rf)t
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You would like to purchase a 1 year call option for RBC stock- the exercise price= $45 per share and the stock price is currently at $70 and the risk free rate=2% and you speculate that the stock will be between $60 and $80 in 1 year.
What is the cost of the option?
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.
t=0t=1
E= $45
S0 =70E=45Rf=2% Both speculated stock prices & t=1 are in the money, therefore:
discount E 1 yr
C0=S0 -E/(1+Rf)t = 70- (45/1.02)1= 25.88
Therefore call option = $25.88
S0 =70
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You would like to purchase a 1 year call option for RBC stock- the exercise price= $45 per share and the stock price is currently at $70
The risk free rate=2% and you speculate that the stock will be between $40 and $80 in 1 year.
What is the cost of the option?
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Call option calculation S0 =70, E=45, Rf=2% & t=1 therefore:
The option can finish out of the $ and be worth 0 at expiration or in the $ and be worth $35
When the stock finishes at $80, our risk-free asset pays $40, leaving us $40 short. Each option is worth $35 in this case, so we need $40/$35 = 1.14options to match the payoff on the stock.
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We must now invest $40 in a risk free asset and in 1.14call options
€
S0=1.14×C0+40
(1+Rf)
€
70=1.14×C0+40
(1.02)
€
C0 =$27.00
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For this case assume a 50% probability for both outcomes
Call option calculationS0 =70, E=45, Rf=2% & t=1 therefore:
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€
C0 =$17.501.02
=$17.16
Therefore value of call option is $17.16
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- Develops tailored to investor characteristics
- Multiple variables that matter in the strategy:- Investment Goals- Anticipation on the underlying asset movement- Risk Level
- Widely used for hedging (as an insurance tool)
- Numerous established strategies out there
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Types:
- Bullish Strategies
- Bearish Strategies
- Neutral Strategies
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- Trader expects underlying asset price to go up - Assess: how high & time frame
- Most bullish strategy - Example: Simple Call Buying Strategy
- Moderate: target price for the bull run & utilize bull spreads to reduce cost
- Maximum profit is capped- Example: Bull Call Spread & Bull Put Spread
- Mildly bullish strategies: make money as long as the underlying stock price does not go down by the expiration date
- Example: Writing Out-of-the-Money Covered Calls
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- Trader expects underlying asset price to go down - Assess: how low & time frame
- Most bearish strategy - Example: Simple Put Buying Strategy
- Moderate: target price for the expected decline & utilize bear spreads to reduce cost
- Maximum profit is capped- Example: Bear Call Spread & Bear Put Spread
- Mildly bullish strategies: make money as long as the underlying stock price does not go up by the expiration date
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- Trader does not know what movement to expect for the underlying asset price
- Also called non-directional strategies: profit does not depend on underlying asset price going up or down
- Correct neutral strategy to employ depends on the expected volatility of the underlying stock price
- Examples:- Straddle: position in a call & a put at the same strike & expiration - Strangle: simultaneous buying or selling of out-of-the-money put & call with same expirations yet different strike prices - Butterfly: buy in-the-money and out-of-the-money call & sell two at the money calls or vice versa - Guts: sell in the money put and call
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Q & Q & AA
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a) the obligation to BUY an underlying asset during a particular period of time
b) the right to BUY an underlying asset during a particular period of time
c) the right to SELL an underlying asset during a particular period of time
d) the obligation to SELL an underlying asset during a particular period of time
A call option is:A call option is:
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a) 2 only b) 3 only c) both 1&4 d) both 2&3
What should a trader who believes that a stock's price will decrease do?
1) buy a call 2) buy a put 3) write a call 4) write a put
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a) American option b) European option c) Bermuda option d) all of these above
Which of the following option(s) could ONLY be exercised on the date of expiration?
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a) the market to go up in movement b) the long call to overlap the short call c) the underlying asset to go up in movement d) the prices of bovine animals to go up in
the near future
Which of the following best completes the below statement?
An option trader exercises a bullish strategy when he/she expects…
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References:TradeKing.com Covered Call Options Strategy. <http://www.youtube.com/watch?v=UT6Y4OZ_Ejc>OptionsPhysics.com Straddles and Strangles. <http://www.youtube.com/watch?v=HPHs7UsjBmY&NR=1>The Options Guide Options & Futures Trading Explained <http://www.theoptionsguide.com/>About.com <http://daytrading.about.com/b/2007/11/18/options-trading-basic-options-strategies.htm>OptionsTradingGuide.com <http://www.option-trading-guide.com/spreads.html>The Options Industry Council Strategies <http://www.optionseducation.org/strategy/default.jsp>Barrie, Scott (2001). The Complete Idiot's Guide to Options and Futures. Alpha Books. pp. 120–121.InvestorWords.com Index Options. < http://www.investorwords.com/2431/index_option.html >OIC< http://www.optionseducation.org/basics/leaps/default.jsp >Index Options. InvestorWords.com, March 18, 2011 Option (finance), Wikipedia, modified on 15 March 2011 at 23:34, < http://en.wikipedia.org/wiki/Option_(finance) > Options Basics: Types of options. Investopedia.com, March 18, 2011 < http://www.investopedia.com/university/options/option3.asp > Black, F. and Myron, S. The Pricing and Corporate Liabilities. Journal of Political Economy, 81, 637-659Cox, J. C., Ross, S.A. and Rubinstein, M. (1979). Option Pricing: A Simplified Approach. Journal of Financial Economics, 7, 229-263Dixit, A. K. and Pindyck, R.S.(1995). The Options Approach to Capital Investment. Harvard Business Review, 73, 105---115.Dale Jackson, BNN Producer 3:32 pm, E.T. February 17,2011 Canadian <http://www.bnn.ca/Blogs/2011/02/17/It-may-be-time-for-alternative-thinking.aspx> Call Options Trading for Beginners - Put and Call Options Explained <http://www.youtube.com/watch?v=q_z1Zx_BALo>Ross S.A., Westerfield R.W., Jordan B.D., Roberts G.S., (2010) Fundamentals of Corporate Finance, Seventh Canadian Edition. Canada: McGraw-Hill RyersonKaplan Schweser Faculty (2010). Chartered Financial Analyst Level 2, Book 5, Derivatives and portfolio management. La Crosse, WI, United States: Kaplan Berk J.,DeMarzo P.M.,Stangeland D.,(2010) Corporate Finance, Canadian Edition, Canada: Pearson Education Canada
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Backup SlidesBackup Slides
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Covered Call StrategyThree main steps:
(1) Purchase the Stock(2) Sell a Single Call Contract(3) Wait for Call to be Exercised or
Expired to Realize Profit
Risk: no protection if stock price goes down
Loss = Purchase Price of Stock – Price of Stock – Premium Received
Maximum Profit = Limited
Profit = Strike Price – Purchase Price of Stock + Premium Received
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Straddle StrategyMain steps:
(1) Buy both a call & a put at the same strike price with same expiration
(2) As the trade begins to move in one direction, trader sell the other
When: trader does not have a clear sense of which direction stock price will move
Goal: underlying stock moves far enough & winning leg of the position makes more money than the losing leg costs.
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Strangle StrategyMain steps:
(1) Buy both a call & a put at the same with same expiration, but different strike prices
(2) As the trade begins to move in one direction, trader sell the other
When: trader does not have a clear sense of which direction stock price will move, but believes the stock is highly volatile
Goal: underlying stock moves far enough & winning leg of the position makes more money than the losing leg costs.Limited Risk: cost of both options may be lost
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Call SpreadFour main steps:
(1) Purchase a single at money call contract(2) Sell a single in money call contract(3) Wait for the price to move above the
long call strike price plus the long call premium
(4) Exercise the long call to realize profit
Low Risk: limited to initial debit taken at entering the trade regardless of how far price moves down Maximum Risk = Initial Debit
Loss = Long Call Premium – Short Call Premium Maximum Profit = Short Call Strike Price – Long Call Strike Price – Initial Debit
Profit = Stock Price Upon Expiration – Long Call Strike Price – Initial Debit
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Put SpreadFour main steps:
(1) Purchase a single at money put contract(2) Sell a single in money put contract(3) Wait for the price to move above the short put
strike price(4) Let both puts expire worthless
Maximum Risk: Difference between long and short put strike prices – Initial Credit
Loss = Short Put Strike Price – Long Put Strike Price- Initial Credit
Maximum Profit = Initial Credit
Profit = Short Put Premium – Long Put Premium
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Payoff from buying a call.
Long callLong call
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A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can control (leverage) a much larger number of shares
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Insurance
Loan guarantees The right to collect from a third party (often a governmental
institution) if the borrower defaults
Employee stock options Incentive form of compensation awarded by the corporation
to employees, as the stock price increase, employees realize profit on either selling the stock or purchase the share at a lower prefixed price.
Other optionsOther options
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Other optionsOther options Real options An option with payoffs in real goods
Index options (stocks market index options) With an index as underlying security, the settlement is made
by cash payment if the option is exersiced.
LEAPS® (Long-Term Equity AnticiPation Securities® )
Options for investors who prepare to carry the position in long term of period.
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The call provision on the bond Held by the corporation, gives the corporation the right to
call back the bond at a fixed price for a fixed time period
Put bonds Gives the holder of the bond the right to force the issuer to
repurchase the bond at a fixed price for a fixed period of time
The overallotment options Gives the underwriters of an IPO the right to purchase
additional shares of stock of the firm
Other optionsOther options
- London engaged in Puts and Refusals (Calls) in 1690: - investors have the right to convert the bond into a common stock- issuers of the bond have the right to buy back the bond at a
specified price
- In 19th century of North America, Privileges were sold, which combine a call and a put on a selected share, expired usually within 3 months
Extra HistoryExtra History
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http://www.slideshare.net/muratcoskun/options-presentation-introduction-to-corporate-finance
