GSB711-Lecture-Note-06-Derivatives-and-Corporate-Finance

GSB711 Managerial Finance – Topic 06 Page No. 1 GSB711 Managerial Finance – Topic 06 Page No. 1

Derivatives and Corporate Finance

Topic 6GSB711 – Managerial Finance

Reading:Chapter: Options (Pages 274 – 299)

Questions: 1, 3, 4, 5, 6 and Problems: 10 and 11.

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Topics Covered

• Calls and Puts• What Determines Option Values?• Spotting the Option

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Option Terminology

Put OptionRight 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 $720

00060120ValuePut

12060000Value Call

840780720660$600PriceStock

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Option ValueCall option value (graphic) given a $720 exercise price.

Share Price

Cal

l opt

ion

valu

e

720 840

$120

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Option ValuePut option value (graphic) given a $720 exercise price.

Share Price

Put

opt

ion

valu

e

600 720

$120

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Option ValueCall option payoff (to seller) given a $720 exercise price.

Share Price

Cal

l opt

ion

$ pa

yoff

720

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Option ValuePut option payoff (to seller) given a $720 exercise price.

Share Price

Put

opt

ion

$ pa

yoff

720

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Option Value

Protective Put - Long stock and long put

Share Price

Pos

ition

Val

ue

Protective Put

Long Put

Long Stock

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Option Value

Protective Put - Long stock and long put

Share Price

Pos

ition

Val

ue

Protective Put

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Option ValueStraddle - Long call and long put - Strategy for profiting from high volatility

Share Price

Pos

ition

Val

ue

Straddle

Long put

Long call

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Option ValueStraddle - Long call and long put - Strategy for profiting from high volatility

Share Price

Pos

ition

Val

ue

Straddle

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Option ValueCall buyer profit – assume strike of

$720 and option price of $80.50

Share Price

Pos

ition

Val

ue

Long call

720 800.50

-80.50

Break even

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Option ValuePut seller profit – assume strike of $720

and option price of $71.20

Share Price

Pos

ition

Val

ue

Short put

648.80 720

+71.20

Break even

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Option ValueStock Price

Upper Limit

Lower Limit

(Stock price - exercise price) or 0

which ever is higher

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Option Value

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Option Value

• Point A -When the stock is worthless, the option is worthless.

• Point B -When the stock price becomes very high, the option price approaches the stock price less the present value of the exercise price.

• Point C -The option price always exceeds its minimum value (except at maturity or when stock price is zero).

• The value of an option increases with both the variability of the share price and the time to expiration.

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Option Value

Components of the Option Price1 - Underlying stock price2 - Striking or Exercise price3 - Volatility of the stock returns (standard deviation

of annual returns)4 - Time to option expiration5 - Time value of money (discount rate)

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Option Value

Black-Scholes Option Pricing Model

OC = Ps[N(d1)] - S[N(d2)]e-rt

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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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Options on Financial Assets

Executive Stock Options – Long term call options given to executives as part of their compensation package.

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.