Options and Corporate Finance

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Options and Corporate Finance

• RWJ Chapter 14

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Synthetic Securities

• Options are synthetic their value is derived
  from the value of other assets in the economy.
• The underlying is the asset from which the the
  options value is derived.
• Most basic examples are calls and puts.
• http//finance.yahoo.com/

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Surprising fact

• Options are redundant. We dont really need
  option trading to replicate option payoffs.
• Lets assume a stock may be worth 140 or 80
  next year, with equal probabilities.
• The discount rate for the stock is 10.
• The stock has a beta of 1.
• T-bills are yielding 5.
• An option on the stock is traded on the NYSE.
  The strike price of this option is 110, and the
  maturity is one year.

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Redundancy Example

• Replicate the payoffs of the stock, using only
  the option.
• It would be equivalent to showing we can
  replicate the payoff of the stock, using only the
  options.

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Summarizing What We Did

• Replicate the payoffs of the stock, using only
  the option.
• Step 1 Find the payoffs of the option in both
  good and bad states.
• Step 2 Choose the right number of options to
  make the difference in outcomes equal to the
  stock.
• Step 3 Now replicate the payoffs by adding the
  right size loan to your option package.

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Example cont.

• An options delta is the percentage the options
  value changes when the stock price changes.
• Find the options delta.
• Options are riskier than the stock.
• Find the options expected return.
• Find the options beta.

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Example 2

• Assume another option trades in the NYSE with
  strike price 120.
• What is this options value?

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The implicit loan in options

• Note that we just showed the option is like a
  levered version of stock.
• Its like buying the stock bundled with
  personal debt.
• One easy way of remembering this consider an
  extremely safe stock, that you know is going to
  be worth 120 next year.
• Consider a call option with strike price 80.
• What is the option worth?

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Bounds on a call options value

• The upper bound is the stock price.
• The lower bound is the intrinsic value (the
  payoff if you exercise immediately.

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Option value determinants
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The usefulness of derivatives in Corporate Finance

• Risk Management
• Stock options
• Now approximately equal to base pay in the US
  (see handout)
• Different than standard options for several
  reasons, and so there is debate over how to value
  them. They are illiquid and manager is
  undiversified.
• Derivatives included in a securities package

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Warrants vs. Call Options

• Options are underwritten by someone. Say I want
  to buy DLQBG.X, which is the right to buy Dell
  puts for next month at 25. (Dell is now trading
  at 34.14).
• Strike Symbol Last Chg Bid Ask Vol Open Int
• 25.00 DLQVE.X 0.05 0.00 N/A 0.10 0 10
• I have to buy this contract from someone. Once I
  do, I have a long put position. The writer has a
  short put position.
• Warrants are securities issued by the firm.

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Warrants vs. Calls cont.

• Warrants are typically attached to loans, or to
  equity IPOs (which are called unit offerings).
• Often these securities detach. Soon after the
  issue, you can sell the warrant, or the stock,
  separately.
• When the warrant is exercised a) there is a new
  cash infusion to the firm (unlike calls) and b)
  the number of shares outstanding changes.
• A convertible bond is a bond with a warrant that
  cannot be detached.

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Convertible Bond Valuation

• Convertible bond value has two floors
• the value if immediately converted (conversion
  value),
• and the value of the straight bond.
• The value of the conversion option is the value
  of the convertible minus the value of the
  straight bond.
• E.g. Let a convertible bond pay 1 annual
  coupons, and let the discount rate be 10. The
  bond is convertible to 1 share at any time with
  the next 5 years. Shares of the stock are now
  worth 14 dollars.
• What would you do if you held this convertible
  bond? What do you think it is worth?
• Note the conversion value and the value of the
  option to convert are not the same thing!