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Slides by Matthew Will

Principles of Corporate Finance Brealey and Myers Sixth Edition. Spotting and Valuing Options. Slides by Matthew Will. Chapter 20. Irwin/McGraw Hill. The McGraw-Hill Companies, Inc., 2000. Topics Covered. Calls, Puts and Shares Financial Alchemy with Options

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Slides by Matthew Will

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  1. Principles of Corporate Finance Brealey and Myers Sixth Edition • Spotting and Valuing Options Slides by Matthew Will Chapter 20 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  2. Topics Covered • Calls, Puts and Shares • Financial Alchemy with Options • What Determines Option Value • Option Valuation

  3. Option Terminology Call Option Right to buy an asset at a specified exercise price on or before the exercise date.

  4. Option Terminology Put Option Right 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.

  5. Option Obligations

  6. Option Value • The value of an option at expiration is a function of the stock price and the exercise price.

  7. 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 $85

  8. Option Value Call option value (graphic) given a $85 exercise price. Call option value $20 85 105 Share Price

  9. Option Value Put option value (graphic) given a $85 exercise price. Put option value $5 80 85 Share Price

  10. Option Value Call option payoff (to seller) given a $85 exercise price. Call option $ payoff 85 Share Price

  11. Option Value Put option payoff (to seller) given a $85 exercise price. Put option $ payoff 85 Share Price

  12. Option Value Protective Put - Long stock and long put Long Stock Position Value Share Price

  13. Option Value Protective Put - Long stock and long put Long Put Position Value Share Price

  14. Option Value Protective Put - Long stock and long put Long Stock Protective Put Position Value Long Put Share Price

  15. Option Value Protective Put - Long stock and long put Protective Put Position Value Share Price

  16. Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Long call Position Value Share Price

  17. Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Long put Position Value Share Price

  18. Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Position Value Share Price

  19. Option Value Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Position Value Share Price

  20. Option Value Stock Price Upper Limit

  21. Option Value Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 whichever is higher

  22. Option Value Components of the Option Price 1 - Underlying stock price 2 - Striking or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate)

  23. Option Value Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt

  24. Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt OC- Call Option Price Ps - Stock Price N(d1) - Cumulative normal density function of (d1) S - Strike or Exercise price N(d2) - Cumulative normal density function of (d2) r - discount rate (90 day comm paper rate or risk free rate) t - time to maturity of option (as % of year) v - volatility - annualized standard deviation of daily returns

  25. Black-Scholes Option Pricing Model Ps S v2 2 ln + ( r + ) t (d1)= v t N(d1)= 32 34 36 38 40

  26. Cumulative Normal Density Function Ps S v2 2 ln + ( r + ) t (d1)= v t (d2) = d1 - v t

  27. Call Option Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365

  28. Call Option Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 Ps S v2 2 ln + ( r + ) t (d1) = v t (d1) = - .3070 N(d1) = 1 - .6206 = .3794

  29. Call Option Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 (d2) = d1 - v t (d2) = - .5056 N(d2) = 1 - .6935 = .3065

  30. Call Option Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 OC = Ps[N(d1)] - S[N(d2)]e-rt OC = 36[.3794] - 40[.3065]e - (.10)(.2466) OC = $ 1.70

  31. Put - Call Parity Put Price = Oc + S - P - Carrying Cost + Div. Carrying cost = r x S x t

  32. Put - Call Parity Example ABC is selling at $41 a share. A six month May 40 Call is selling for $4.00. If a May $ .50 dividend is expected and r=10%, what is the put price?

  33. Put - Call Parity Example ABC is selling at $41 a share. A six month May 40 Call is selling for $4.00. If a May $ .50 dividend is expected and r=10%, what is the put price? Op = Oc + S - P - Carrying Cost + Div. Op = 4 + 40 - 41 - (.10x 40 x .50) + .50 Op = 3 - 2 + .5 Op = $1.50

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