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Understanding options. Chapter 20. Principles of corporate finance
1. Understanding options
Chapter20
UNDERSTANDING OPTIONS
Brealey, Myers, and Allen
Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
2. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Call Option
• Right to buy an asset at specified price on or
before exercise date
• Put Option
• Right to sell asset at specified price on or
before exercise date
20-2
20-2
3. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Option Obligations
Long
Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
20-3
20-3
4. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Derivatives
• Financial instrument created from another
instrument
• Option Premium
• Price paid for option, above price of underlying
security
• Intrinsic Value
• Difference between strike price and stock price
• Time Premium
• Value of option above intrinsic value
20-4
20-4
5. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Exercise Price (Strike Price)
• Price at which security is bought or sold
• Expiration Date
• Last date on which option can be exercised
• American Call
• Can be exercised any time up to expiration date
• European Call
• Can only be exercised on expiration date
20-5
20-5
6. Table 20.1 options on apple stock, October 2011
TABLE 20.1 OPTIONS ON APPLE STOCK,OCTOBER 2011
20-6
20-6
7. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Option Value
• Value at expiration is a function of stock price
and exercise price
• Example
• Option values given exercise price of $80
Stock Price $60
Call value
0
Put value
20
70
0
10
80
0
0
90
10
0
100
20
0
110
30
0
20-7
20-7
8. Figure 20.1a apple position diagram, call
FIGURE 20.1A APPLE POSITION DIAGRAM,CALL
20-8
20-8
9. Figure 20.1b apple position diagram, put
FIGURE 20.1B APPLE POSITION DIAGRAM,PUT
20-9
20-9
10. Figure 20.2a payoff to seller of apple call
FIGURE 20.2A PAYOFF TO SELLER OFAPPLE CALL
20-10
20-10
11. Figure 20.2b payoff to seller of apple put
FIGURE 20.2B PAYOFF TO SELLER OFAPPLE PUT
20-11
20-11
12. Figure 20.3a profit diagram for apple
FIGURE 20.3A PROFIT DIAGRAM FORAPPLE
20-12
20-12
13. Figure 20.3b profit diagram for apple
FIGURE 20.3B PROFIT DIAGRAM FORAPPLE
20-13
20-13
14. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Position Diagram
• Long stock and short call
Long stock
Position value
Poor strategy
Short call
Share price
20-14
20-14
15. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Position Diagram
• Protective put: long stock and long put
Long stock
Position value
Protective put
Long put
Share price
20-15
20-15
16. 20-1 calls, puts, and shares
20-1 CALLS, PUTS, AND SHARES• Position Diagram
• Straddle: long call and long put
Long call
Position value
Long put
Straddle
Share price
20-16
20-16
17. Figure 20.4 six-month payoff options, apple
FIGURE 20.4 SIX-MONTH PAYOFF OPTIONS,APPLE
20-17
20-17
18. Figure 20.5 options
FIGURE 20.5 OPTIONS20-18
20-18
19. Figure 20.6 protection strategies
FIGURE 20.6 PROTECTION STRATEGIES20-19
20-19
20. Figure 20.7 call to put
FIGURE 20.7 CALL TO PUT20-20
20-20
21. Figure 20.8 ticket payoff
FIGURE 20.8 TICKET PAYOFF20-21
20-21
22. Figure 20.9 call purchase and sale
FIGURE 20.9 CALL PURCHASE AND SALE20-22
20-22
23. 20-3 what determines option values?
20-3 WHAT DETERMINES OPTIONVALUES?
• Components of Option Price
• Underlying stock price = Ps
• Striking or exercise price = S
• Volatility of stock returns (standard deviation of
annual returns) = v
• Time to option expiration = t = days/365
• Time value of money (discount rate) = r
• PV of dividends = D = (div)e−rt
20-23
20-23
24. Time decay chart
TIME DECAY CHART• Option price decreases, all other things
equal, as time to expiration decreases
Option
price
90 days to expiration
30 days to expiration
60 days to expiration
Stock price
20-24
20-24
25. 20-3 what determines option values?
20-3 WHAT DETERMINES OPTIONVALUES?
Stock price
Upper limit
Lower limit
(Stock price - exercise price) or
0, whichever is higher
20-25
20-25
26. Figure 20.10 value of call before expiration date
FIGURE 20.10 VALUE OF CALL BEFOREEXPIRATION DATE
20-26
20-26
27. Figure 20.11 call options, firms x and y
FIGURE 20.11 CALL OPTIONS, FIRMS X AND Y• In each case, current
share price equals
exercise price; each
option has 50%
chance of success or
failure
• Firm Y has greater
chance of large payoff
because it is more
volatile
20-27
20-27
28. Figure 20.12 apple call option value versus stock price
FIGURE 20.12 APPLE CALL OPTION VALUEVERSUS STOCK PRICE
20-28
20-28
29. Table 20.2 determinants of call price
TABLE 20.2 DETERMINANTS OF CALLPRICE
20-29
20-29
30. Table 20.3 executive stock options
TABLE 20.3 EXECUTIVE STOCK OPTIONS20-30
20-30