T22.1 Chapter Outline

1
Chapter 25Options and Corporate Securities

• Homework 2, 3,12, 13

2
Lecture Organization

• Options The Basics
• Fundamentals of Option Valuation
• Other Options
• Hedging with Option Contracts

3
Option Terminology

• Call option
• The right to buy an asset at a fixed price
  during a particular period of time.
• Put option
• The right to sell an asset at a fixed price
  during a particular period of time. The opposite
  of a call.
• Striking price
• The fixed price in the option contract at which
  the holder can buy or sell the underlying asset.
  (Also the exercise price or the strike price.)

4
Option Terminology

• Expiration date
• The last day on which an option may be
  exercised.
• Exercising the option
• The act of buying or selling the underlying
  asset via the option contract.
• American option
• An option that may be exercised at any time
  until its expiration date.
• European option
• An option that may only be exercised on the
  expiration date.

5
Call Options Let's say you look in the WSJ on
9/28/2001 and see IBM trading for 69 per share.
You think that IBM is going to go up in price.
How do you make money? a) b)
6
Example Assume that you own the right to buy IBM
for 70/share in January. Fill in the following
table
7
Put options You think that IBM is going to go
down in price in January. How do you make
money? Let's say you owned the right to sell one
share of IBM stock in January for 70/share.
January rolls around and the price of IBM has
fallen to 60/share. How can you profit from
your option?
8
Example Assume that you own the right to sell
IBM for 70/share in January. Fill in the
following table
9
Short Calls Example Say you sell 100 November
IBM calls with a strike price of 75. The price
of each option is 0.87. Hence you would collect
87 today. When you sell a call option to
someone, you are selling them the right to buy
100 shares of IBM stock from you for 75/share in
November.
10
Short Puts Example Say you sell 100 November
IBM puts with a strike price of 75. The price
of each option is 7.00. Hence you would collect
700.00 today. When you sell a put option to
someone, you are selling them the right to sell
100 shares of IBM stock to you for 75/share in
November.
11
A Sample Globe and Mail, Report on Business
Option Quote (Figure 25.1)
Stock
Close
Total Vol
Op Int
Series
Bid
Ask
Last
Vol
Op Int
Air Canada
19.35
156
8514
Jul-00
16.00
3.35
3.60
3.95
7
592
19.00
p
0.60
0.85
0.55
20
150
20.00
0.60
0.85
0.90
20
230
21.00
0.30
0.55
0.50
40
104
Source The Globe and Mail, Report on Business,
July 6, 2000, p. B27. Used with permission
12
Value of a Call Option at Expiration (Figure 25.2)
Call option value at expiration (C1)
S1 ? E
S1 gt E
Stock price at expiration (S1)
45

Exercise price (E)
As shown, the value of a call at expiration is
equal to zero if the stock price is less than or
equal to the exercise price. The value of the
call is equal to the stock price minus the
exercise price (S1 - E) if the stock price
exceeds the exercise price.
13
Value of a Call Option Before Expiration (Figure
25.3)
Call price (C0)
Lower bound C0 ? S0 - E C0 ? 0
Upper bound C0 ? S0
45

Stock price (S0)
Exercise price (E)
As shown, the upper bound on a calls value is
given by the value of the stock (C0 ? S0). The
lower bound is either S0 - E or zero, whichever
is larger.
14
Five Factors That Determine Option Values
Factor Calls Puts

• Current value of the underlying asset
• Exercise price on the option
• Time to expiration on the option
• Risk-free rate
• Variance of return on underlying asset

15
Warrants and Convertible Bonds

• Warrant
• A call option issued by firms that provides the
  buyer the right to purchase shares of stocks at a
  specified price over a given period of time.
• Convertible bonds
• Can be exchanged into a fixed number of stocks
  anytime up to and including the maturity date of
  the bond. Cannot be separated from the bond.

16
Other Options

• Call provision on a bond
• A call provision provides the issuer the right,
  but not the obligation to repurchase the bond at
  a specified price.
• Put bonds
• The owner of a put bond has the right to force
  the issuer to repurchase the bond for a fixed
  price for a fixed period of time.
• Green Shoe provision
• The right of the underwriter to purchase
  additional shares from the issuer at the offer
  price in an IPO.
• Insurance
• Insurance obligates the insurer to purchase the
  underlying asset at a specified price for a
  specified period (the term of the policy).

17
Risk Profile for a Wheat Grower
18
Risk Profile for a Wheat Buyer
19
Option Payoff Profiles
? V
? P
A. Buying a call
20
Option Payoff Profiles (continued)
? V
? P
B. Selling a call
21
Option Payoff Profiles (continued)
? V
? P
C. Buying a put
22
Option Payoff Profiles (concluded)
? V
? P
D. Selling a put
23
Sample National Post Future Option Price
Quotations (Figure 24.16)
FUTURE OPTION PRICES Thursday, June 1, 2000
The National Post, June 1, 2000. Used with
permission.
24
Example
Consider the following options quote.

• Option Strike Calls Puts
• NY Close Price Expiration Vol. Last Vol. Last
• RWJR
• 74 70 Mar 230 3 1/2 160 1 1/8
• 74 70 Apr 170 6 127 1 7/8
• 74 70 Jul 139 8 5/8 43 3 3/8
• 74 70 Oct 60 9 7/8 11 3 1/8

25
Solution to Example

• a. Are the call options in the money? What is the
  intrinsic value of an RWJR Corp. call option?
• b. Are the put options in the money? What is the
  intrinsic value of an RWJR Corp. put option?
• c. Two of the options are clearly mispriced.
  Which ones? At a minimum, what should the
  mispriced options sell for? Explain how you could
  profit from the mispricing in each case.