Chapter 18: Options Basics

1. Chapter 18:Options Basics Corporate Finance, 3e Graham, Smart, and Megginson

2. Options and other derivative securities have several important economic functions: • Can help align managerial interests with those of shareholders • Help bring about more efficient allocation of risk • Save transactions costs…sometimes it is cheaper to trade a derivative than its underlying asset. • Permit investment strategies that would not otherwise be possible Economic Benefits Provided by Options • Derivative securities are instruments that derive their value from the value of other assets. Derivatives include options, futures, and swaps.

3. Call option • Gives the holder the right to purchase an asset at a specified price on or before a certain date • Gives the holder the right to sell an asset at a specified price on or before a certain date Put option • American options allow holders to exercise at any point prior to expiration. • European options allow holders to exercise only on the expiration date. American or European option Options Vocabulary • Strike price or exercise price: The price specified for purchase or sale in an option contract

4. Long position • The buyer of an option has a long position, and has the ability to exercise the option. • The seller (or writer) of an option has a short position, and must fulfill the contract if the buyer exercises. • As compensation, the seller receives the option premium from the buyer. Short position Options Trading • Options trade on an exchange (such as CBOE) or in the over-the-counter market.

5. Option Prices S = Current stock price X = Strike price

6. For in the money options: The difference between the current price of the underlying asset and the strike price • For out of the money options, the intrinsic value is zero. Intrinsic value • The difference between the option’s intrinsic value and its market price (premium) Time value Intrinsic and Time Value of Options

7. Long and short positions Use payoff diagrams for: Gross and net positions (the net positions subtract the option premium) Payoff Diagrams • Show the value of an option, or the value at expiration • Y-axis plots exercise value or “intrinsic value.” • X-axis plots price of underlying asset. Payoff: The price of the option at expiration date

8. Naked Option Positions • Naked call option position – Occurs when an investor buys or sells an option on a stock without having a position in the underlying stock • Naked put option positions – Occurs when a trader buys or sells a put option without having a position in the underlying stock • These positions are purely speculative.

9. Portfolios of Options Look at payoff diagrams for combinations of options rather than just one Diagrams show the range of potential strategies made possible by options. Some positions, in combination with other positions, can be a form of portfolio insurance.

10. Straddle Positions • Long straddle A portfolio consisting of long positions in calls and puts on the same stock with the same strike price and expiration date • Short straddle  A portfolio consisting of short positions in calls and puts on the same stock with the same strike price and expiration date

11. Covered Call Strategy • Writing covered calls – Common trading strategy that mixes stock and call options • An investor who owns a share of stock sells a call option on that stock. • The investor receives the option premium immediately. • The trade-off is that if the stock price rises… • the holder of the call option will exercise the right to purchase it at the strike price, and • the investor will lose the opportunity to benefit from the appreciation in the stock.

12. Put-Call Parity • For this formula to hold, the call and put options must… • be on the same underlying stock, • have the same exercise price, • share the same expiration date, and • be European options. • In addition, the following conditions must hold: • The underlying stock must not pay a dividend during the life of the options. • The bond must be a risk-free, zero-coupon bond with a face value equal to the strike price of the options and with a maturity date identical to the options’ expiration date.

13. Price of underlying asset • Asset price and call price are positively related. • Asset price and put price are negatively related. Time to expiration • More time usually makes options more valuable. Strike price • Higher X means higher put price; lower X means higher call price. Volatility • Options are more valuable when the underlying asset’s price is more volatile. Factors Affecting Option Values

14. Binomial Option Pricing • The binomial options model recognizes that investors can combine options (either calls or puts) with shares of the underlying asset to construct a portfolio with a risk-free payoff. • Data needed: • The current price of the underlying stock • The time remaining before the option expires • The strike price of the option • The risk-free rate • The possible values of the underlying stock in the future

15. Risk-Neutral Method • If a combination of stock and options is risk-free, it must earn the same return as a risk-free bond. • If an asset promises a risk-free payoff, risk-averse and risk-neutral investors agree on how it should be valued. • Whether investors are risk averse or risk neutral, the binomial model’s calculations are the same. • We can assume investors are risk neutral, which gives us a new way to value options.