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.