Chapter 25Options and Corporate

Securities

•Homework: 2, 3,12, & 13

Lecture Organization

Options: The Basics

Fundamentals of Option Valuation

Other Options

Hedging with Option Contracts

Option Terminology

Call option

The right to buy an asset at a fixed price during a particular period of time.

Put option

The right to sell an asset at a fixed price during a particular period of time. The opposite of a call.

Striking price

The fixed price in the option contract at which the holder can buy or sell the underlying asset. (Also the exercise price or the strike price.)

Option Terminology

Expiration date

The last day on which an option may be exercised.

Exercising the option

The act of buying or selling the underlying asset via the option contract.

American option

An option that may be exercised at any time until its expiration date.

European option

An option that may only be exercised on the expiration date.

Call Options

Let's say you look in the WSJ on 9/28/2001 and see IBM trading for $69 per share. You think that IBM is going to go up in price. How do you make money?

a)

b)

Example: Assume that you own the right to buy IBM for $70/share in January. Fill in the following table:

Price of IBM Exercise @ Gross Stock in Jan. $70 (Y/N) Payoff

55606570758085

Put options

You think that IBM is going to go down in price in January. How do you make money?

Let's say you owned the right to sell one share of IBM stock in January for $70/share. January rolls around and the price of IBM has fallen to $60/share. How can you profit from your option?

Example: Assume that you own the right to sell IBM for $70/share in January. Fill in the following table:

Price of IBM Exercise @ Gross Stock in Jan. $70 (Y/N) Payoff

55606570758085

Short Calls

Example: Say you sell 100 November IBM calls with a strike price of $75. The price of each option is $0.87. Hence you would collect $87 today.

When you sell a call option to someone, you are selling them the right to buy 100 shares of IBM stock from you for $75/share in November.

Short Puts

Example: Say you sell 100 November IBM puts with a strike price of $75. The price of each option is $7.00. Hence you would collect $700.00 today.

When you sell a put option to someone, you are selling them the right to sell 100 shares of IBM stock to you for $75/share in November.

A Sample Globe and Mail, Report on Business Option Quote (Figure 25.1)

Source: The Globe and Mail, Report on Business, July 6, 2000, p. B27. Used with permission

Stock Close Total Vol Op IntSeries Bid Ask Last Vol Op Int

Air Canada $19.35 156 8514Jul-00 $16.00 3.35 3.60 3.95 7 592

$19.00 p 0.60 0.85 0.55 20 150$20.00 0.60 0.85 0.90 20 230$21.00 0.30 0.55 0.50 40 104

Value of a Call Option at Expiration (Figure 25.2)

Stock price

at expiration (S1)

Call option value

at expiration (C1)

S1 E S1 > E

Exercise price (E)45 °

As shown, the value of a call at expiration is equal to zero if the stock price is less than or equal to the exercise price. The value of the call is equal to the stock price minus the exercise price (S1 - E) if the stock price exceeds the exercise price.

Value of a Call Option Before Expiration (Figure 25.3)

Stock price (S0)

Call price

(C0)

Exercise price (E)

45 °

Lower bound

C0 S0 - E

C0 0

Upper bound

C0 S0

As shown, the upper bound on a call’s value is given by the value of the stock (C0 S0). The lower bound is either S0 - E or zero, whichever is larger.

Five Factors That Determine Option Values

Current value of the underlying asset

Exercise price on the option

Time to expiration on the option

Risk-free rate

Variance of return on underlying asset

Factor Calls Puts

Warrants and Convertible Bonds

Warrant

A call option issued by firms that provides the buyer the right to purchase shares of stocks at a specified price over a given period of time.

Convertible bonds

Can be exchanged into a fixed number of stocks anytime up to and including the maturity date of the bond. Cannot be separated from the bond.

Other Options

Call provision on a bond

A call provision provides the issuer the right, but not the obligation to repurchase the bond at a specified price.

Put bonds

The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed price for a fixed period of time.

Green Shoe provision

The right of the underwriter to purchase additional shares from the issuer at the offer price in an IPO.

Insurance

Insurance obligates the insurer to purchase the underlying asset at a specified price for a specified period (the term of the policy).

Risk Profile for a Wheat Grower

Risk Profile for a Wheat Buyer

Option Payoff Profiles

V

P

A. Buying a call

Option Payoff Profiles (continued)

B. Selling a call

V

P

Option Payoff Profiles (continued)

C. Buying a put

V

P

Option Payoff Profiles (concluded)

D. Selling a put

V

P

Sample National Post Future Option Price Quotations (Figure 24.16)

FUTURE OPTION PRICESThursday, June 1, 2000

The National Post, June 1, 2000. Used with permission.

StrikeCanola (WPG)20 metric tons, C$ per metric tonStrike July Aug Sept July Aug Sept240 18.80 23.40 s r 1.10 s250 9.50 15.40 18.30 1.00 3.00 4.00260 3.00 9.10 12.10 3.90 6.60 7.60270 1.00 4.80 7.40 11.70 12.20 12.80280 0.50 2.20 4.20 21.20 19.60 19.50290 r 0.90 2.20 31.10 28.20 27.40300 r 0.30 1.10 41.10 37.50 36.10310 r 0.10 0.50 51.10 47.20 45.40320 r r 0.20 61.00 57.10 55.00Prev. open int. 9,580 Prev. open int. 9,943

Calls-Settle Puts-Settle

Example

Option & Strike Calls Puts

NY Close Price Expiration Vol. Last Vol. Last

RWJR

74 70 Mar 230 3 1/2 160 1 1/8

74 70 Apr 170 6 127 1 7/8

74 70 Jul 139 8 5/8 43 3 3/8

74 70 Oct 60 9 7/8 11 3 1/8

Consider the following options quote.

Solution to Example

a. Are the call options in the money? What is the intrinsic value of an RWJR Corp. call option?

b. Are the put options in the money? What is the intrinsic value of an RWJR Corp. put option?

c. Two of the options are clearly mispriced. Which ones? At a minimum, what should the mispriced options sell for? Explain how you could profit from the mispricing in each case.