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This is the sixth presentation from Dr Subba Reddy Yarram for GSB711 Managerial Finance, for students of the Graduate School of Business at the University of New England. In this presentation, derivatives and corporate finance are explained.
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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.
GSB711 Managerial Finance – Topic 06 Page No. 2 GSB711 Managerial Finance – Topic 06 Page No. 2
Topics Covered
• Calls and Puts• What Determines Option Values?• Spotting the Option
GSB711 Managerial Finance – Topic 06 Page No. 3 GSB711 Managerial Finance – Topic 06 Page No. 3
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.
GSB711 Managerial Finance – Topic 06 Page No. 4 GSB711 Managerial Finance – Topic 06 Page No. 4
Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
GSB711 Managerial Finance – Topic 06 Page No. 5 GSB711 Managerial Finance – Topic 06 Page No. 5
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
GSB711 Managerial Finance – Topic 06 Page No. 6 GSB711 Managerial Finance – Topic 06 Page No. 6
Option ValueCall option value (graphic) given a $720 exercise price.
Share Price
Cal
l opt
ion
valu
e
720 840
$120
GSB711 Managerial Finance – Topic 06 Page No. 7 GSB711 Managerial Finance – Topic 06 Page No. 7
Option ValuePut option value (graphic) given a $720 exercise price.
Share Price
Put
opt
ion
valu
e
600 720
$120
GSB711 Managerial Finance – Topic 06 Page No. 8 GSB711 Managerial Finance – Topic 06 Page No. 8
Option ValueCall option payoff (to seller) given a $720 exercise price.
Share Price
Cal
l opt
ion
$ pa
yoff
720
GSB711 Managerial Finance – Topic 06 Page No. 9 GSB711 Managerial Finance – Topic 06 Page No. 9
Option ValuePut option payoff (to seller) given a $720 exercise price.
Share Price
Put
opt
ion
$ pa
yoff
720
GSB711 Managerial Finance – Topic 06 Page No. 10 GSB711 Managerial Finance – Topic 06 Page No. 10
Option Value
Protective Put - Long stock and long put
Share Price
Pos
ition
Val
ue
Protective Put
Long Put
Long Stock
GSB711 Managerial Finance – Topic 06 Page No. 11 GSB711 Managerial Finance – Topic 06 Page No. 11
Option Value
Protective Put - Long stock and long put
Share Price
Pos
ition
Val
ue
Protective Put
GSB711 Managerial Finance – Topic 06 Page No. 12 GSB711 Managerial Finance – Topic 06 Page No. 12
Option ValueStraddle - Long call and long put - Strategy for profiting from high volatility
Share Price
Pos
ition
Val
ue
Straddle
Long put
Long call
GSB711 Managerial Finance – Topic 06 Page No. 13 GSB711 Managerial Finance – Topic 06 Page No. 13
Option ValueStraddle - Long call and long put - Strategy for profiting from high volatility
Share Price
Pos
ition
Val
ue
Straddle
GSB711 Managerial Finance – Topic 06 Page No. 14 GSB711 Managerial Finance – Topic 06 Page No. 14
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
GSB711 Managerial Finance – Topic 06 Page No. 15 GSB711 Managerial Finance – Topic 06 Page No. 15
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
GSB711 Managerial Finance – Topic 06 Page No. 16 GSB711 Managerial Finance – Topic 06 Page No. 16
Option ValueStock Price
Upper Limit
Lower Limit
(Stock price - exercise price) or 0
which ever is higher
GSB711 Managerial Finance – Topic 06 Page No. 17 GSB711 Managerial Finance – Topic 06 Page No. 17
Option Value
GSB711 Managerial Finance – Topic 06 Page No. 18 GSB711 Managerial Finance – Topic 06 Page No. 18
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.
GSB711 Managerial Finance – Topic 06 Page No. 19 GSB711 Managerial Finance – Topic 06 Page No. 19
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)
GSB711 Managerial Finance – Topic 06 Page No. 20 GSB711 Managerial Finance – Topic 06 Page No. 20
Option Value
Black-Scholes Option Pricing Model
OC = Ps[N(d1)] - S[N(d2)]e-rt
GSB711 Managerial Finance – Topic 06 Page No. 21 GSB711 Managerial Finance – Topic 06 Page No. 21
Options on Real Assets
Real Options - Options embedded in real assets
GSB711 Managerial Finance – Topic 06 Page No. 22 GSB711 Managerial Finance – Topic 06 Page No. 22
Options on Real Assets
Real Options - Options embedded in real assets
Option to Expand
Option to Abandon
GSB711 Managerial Finance – Topic 06 Page No. 23 GSB711 Managerial Finance – Topic 06 Page No. 23
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.
