Chapter 8

Financial Options and

Applications in Corporate
Finance
1

Topics in Chapter

Financial Options Terminology

Option Price Relationships
Black-Scholes Option Pricing Model
Put-Call Parity

The Big Picture:

The Value of a Stock Option
Cost of
equity (rs)

D1
Stock Price =
(1 + rs )1

Risk-free bond

Dividends
(Dt)

D2
+
(1 + rs)2

Portfolio of stock and

risk-free bond that
replicates cash flows
of the option

... +

D
+
(1 + rs)

Value of option must

be the same as the
replicating portfolio

What is a financial option?

An option is a contract which gives

its holder the right, but not the
obligation, to buy (or sell) an asset
at some predetermined price
within a specified period of time.

What is the single most

important
characteristic of an option?

It does not obligate its owner to

take any action. It merely gives
the owner the right to buy or sell
an asset.

Option Terminology

Call option: An option to buy a

specified number of shares of a
security within some future period.
Put option: An option to sell a
specified number of shares of a
security within some future
period.
6

Option Terminology

Strike (or exercise) price: The

price stated in the option contract
at which the security can be
bought or sold.
Expiration date: The last date the
option can be exercised.

Option Terminology
(Continued)

Exercise value: The value of a call

option if it were exercised today =

Max[0, Current stock price - Strike

price]
Note: The exercise value is zero if the
stock price is less than the strike
price.

Option price: The market price of

the option contract.
8

Option Terminology
(Continued)

Time value: Option price minus the

exercise value. It is the additional
value because the option has
remaining time until it expires.

Option Terminology
(Continued)

Writing a call option: For every new

option, there is an investor who
writes the option.

A writer creates the contract, sells it

to another investor, and must fullfill
the option contract if it is exercised.
For example, the writer of a call must
be prepared to sell a share of stock to
the investor who owns the call.
10

Option Terminology
(Continued)

Covered option: A call option

written against stock held in an
investors portfolio.
Naked (uncovered) option: An
option written without the stock to
back it up.

11

Option Terminology
(Continued)

In-the-money call: A call whose

strike price is less than the current
price of the underlying stock.
Out-of-the-money call: A call
option whose strike price exceeds
the current stock price.

12

Option Terminology
(Continued)

LEAPS: Long-term Equity

AnticiPation Securities that are
similar to conventional options
except that they are long-term
options with maturities of up to 2
years.

13

Consider the following

data:
Strike price = $25.
Stock Price
Call Option Price
$25
$3.00
30
7.50
35
12.00
40
16.50
45
21.00
50
25.50
14

Exercise Value of Option

Price of
stock (a)

Strike
price (b)

Exercise value
of option (a)(b)

$25.00
30.00
35.00
40.00
45.00
50.00

$25.00
25.00
25.00
25.00
25.00
25.00

$0.00
5.00
10.00
15.00
20.00
25.00
15

Market Price of Option

Price of Strike
Exer. Mkt. Price
stock
price val. (c) of opt. (d)
(a)
(b)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00
12.00
40.00
25.00 15.00
16.50
45.00
25.00 20.00
21.00
50.00
25.00 25.00
25.50
16

Time Value of Option

Price of Strike
Exer.
Mkt. P
of
stock
price Val. (c)
(a)
(b)
opt. (d)
$25.00 $25.00 $0.00
$3.00
30.00
25.00
5.00
7.50
35.00
25.00 10.00 12.00
40.00
25.00 15.00 16.50
45.00
25.00 20.00 21.00
50.00
25.00 25.00 25.50

Time
value
(d) (c)
$3.00
2.50
2.00
1.50
1.00
0.50
17

Call Time Value Diagram

Option value

30
25
20
Market price

15
Exercise value

10
5

10

15

20

25

30

35

40

18

Stock Price

Option Time Value Versus

Exercise Value

The time value, which is the option

price less its exercise value,
declines as the stock price
increases.
This is due to the declining degree
of leverage provided by options as
the underlying stock price
increases, and the greater loss
potential of options at higher
19

The Binomial Model

Stock assumptions:

Current price: P = $27

In next 6 months, stock can either

Go up by factor of 1.41
Go down by factor of 0.71

Call option assumptions

Expires in t = 6 months = 0.5 years

Exercise price: X = $25
Risk-free rate: rRF = 6%
20

Binomial Payoffs at Calls

Expiration
Ending "up" stock price = P(u) = $38.07
Option payoff: Cu = MAX[0,P(u)X] = $13.07
Current
stock price
P = $27
Ending down" stock price = P(d) = $19.17
Option payoff: Cd = MAX[0,P(d)X] = $0.00
u = 1.41
d = 0.71
X = $25
21

Create portfolio by writing 1

option and buying Ns shares of
stock.

Portfolio payoffs:

Stock is up: Ns(P)(u) Cu

Stock is down: Ns(P)(d) Cd

22

The Hedge Portfolio with a

Riskless Payoff

Set payoffs for up and down equal,

solve for number of shares:

Ns= (Cu Cd) / P(u d)

In our example:

Ns= ($13.07 $0) / $27(1.41 0.71)

Ns=0.6915
23

Riskless Portfolios Payoffs

at Calls Expiration: $13.26
Ending "up" stock price = P(u) = $38.07

Current
stock price
P = $27

Ending "up" stock value = NsP(u) = $26.33

Option payoff: Cu = MAX[0,P(u)X] = $13.07
Portfolio's net payoff = P(u)Ns - Cu = $13.26

Ending down" stock price = P(d) = $19.17

u = 1.41
d = 0.71
X = $25
Ns = 0.6915

Ending down" stock value = NsP(d) = $13.26

Option payoff: Cd = MAX[0,P(d)X] = $0.00
Portfolio's net payoff = P(d)Ns - Cd = $13.26
24

Riskless payoffs earn the

risk-free rate of return.

Discount at risk-free rate

compounded daily.
VPortfolio = PV of riskless payoff
VPortfolio = Payoff / (1 + rRF/365)365*t
VPortfolio = $13.26 / (1 +
0.06/365)365*0.5
VPortfolio = $12.87
25

The Value of the Call

Option

Because the portfolio is riskless:

By definition, the value of the

portfolio is:

VPortfolio = PV of riskless payoff

VPortfolio = Ns(P) VC

Equating these and rearranging,

we get the value of the call:

VC = Ns(P) PV of riskless payoff

26

Value of Call

VC = Ns(P) Payoff / (1 +
rRF/365)365*t
VC = 0.6915($27)
$13.26 / (1 + 0.06/365)365*0.5
= $18.67 $12.87
= $5.80

(VC = $5.81 if no rounding in any intermediate

27
steps.)

Multi-Period Binomial
Pricing

If you divided time into smaller periods

and allowed the stock price to go up or
down each period, you would have a
more reasonable outcome of possible
stock prices when the option expires.
This type of problem can be solved with
a binomial lattice.
As time periods get smaller, the
binomial option price converges to the
Black-Scholes price, which we discuss in
later slides.
28

Replicating Portfolio

From the previous slide we have:

VC = Ns(P) Payoff / (1 + rRF/365)365*t
The right side of the equation is the
same as creating a portfolio by buying
Ns shares of stock and borrowing an
amount equal to the present value of
the hedge portfolios riskless payoff
(which must be repaid).
The payoffs of the replicating portfolio
are the same as the options payoffs.
29

Replicating Portfolio
Payoffs: Amount Borrowed
and Repaid

Amount borrowed:

PV of payoff = $12.87

Repayment due to borrowing this

amount:

Repayment = $12.87 (1 + rRF/365)365*t

Repayment = $13.26
Notice that this is the same as the
payoff of the hedge portfolio.
30

Replicating Portfolio Net

Payoffs

Stock up:

Stock down:

Value of stock = 0.6915($38.07) =$26.33

Repayment of borrowing = $13.26
Net portfolio payoff = $13.07
Value of stock = 0.6915($19.17) =$13.26
Repayment of borrowing = $13.26
Net portfolio payoff = $0

Notice that the replicating portfolios

payoffs exactly equal those of the
option.
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Replicating Portfolios and

Arbitrage

The payoffs of the replicating portfolio

exactly equal those of the call option.
Cost of replicating portfolio
= Ns(P) Amount borrowed
= 0.6915($27) $12.87
= $18.67 $12.87
= $5.80

If the call options price is not the same

as the cost of the replicating portfolio,
then there will be an opportunity for
32
arbitrage.

Arbitrage Example

Suppose the option sells for $6.

You can write option, receiving $6.

Create replicating portfolio for $5.80,
netting $6.00 $5.80 = $0.20.

Arbitrage:

You invested none of your own money.

You have no risk (the replicating portfolios
payoffs exactly equal the payoffs you will
owe because you wrote the option.
You have cash ($0.20) in your pocket.
33

Arbitrage and Equilibrium

Prices

If you could make a sure arbitrage

profit, you would want to repeat it (and
so would other investors).
With so many trying to write (sell)
options, the extra supply would drive
the options price down until it reached
$5.80 and there were no more arbitrage
profits available.
The opposite would occur if the option
sold for less than $5.80.
34

Assumptions of the
Black-Scholes Option Pricing
Model

The stock underlying the call

option provides no dividends
during the call options life.
There are no transactions costs for
the sale/purchase of either the
stock or the option.
Risk-free rate, rRF, is known and
constant during the options life.
(More...)
35

Assumptions (Continued)

Security buyers may borrow any

fraction of the purchase price at the
short-term risk-free rate.
No penalty for short selling and sellers
receive immediately full cash proceeds
at todays price.
Call option can be exercised only on its
expiration date.
Security trading takes place in
continuous time, and stock prices move
randomly in continuous time.
36

What are the three

equations that make up
the OPM?
VC = P[N(d1)] - Xe -rRFt[N(d2)]
ln(P/X) + [rRF + (2/2)]t
d1 =

t 0.5

d2 = d1 - t 0.5
37

What is the value of the

following call option
according to the OPM?

Assume:
P = $27
X = $25
rRF = 6%
t = 0.5 years
= 0.49
38

First, find d1 and d2.

d1 = {ln($27/$25) + [(0.06 + 0.492/2)]
(0.5)}
{(0.49)(0.7071)}
d1 = 0.4819
d2 = 0.4819 - (0.49)(0.7071)
d2 = 0.1355

39

Second, find N(d1) and

N(d2)

N(d1) = N(0.4819) = 0.6851

N(d2) = N(0.1355) = 0.5539

Note: Values obtained from Excel

using NORMSDIST function. For
example:
N(d1) = NORMSDIST(0.4819)
40

Third, find value of option.

VC = $27(0.6851) - $25e-(0.06)(0.5)
(0.5539)
= $19.3536 - $25(0.97045)
(0.6327)
= $5.06
41

What impact do the following

parameters have on a call options
value?

Current stock price: Call option

value increases as the current
stock price increases.
Strike price: As the exercise price
increases, a call options value
decreases.

42

Impact on Call Value

(Continued)

Option period: As the expiration date is

lengthened, a call options value
increases (more chance of becoming in
the money.)
Risk-free rate: Call options value tends
to increase as rRF increases (reduces the
PV of the exercise price).
Stock return variance: Option value
increases with variance of the
underlying stock (more chance43of

Put Options

A put option gives its holder the

right to sell a share of stock at a
specified stock on or before a
particular date.

44

Put-Call Parity

Portfolio 1:

Put option,
Share of stock, P

Portfolio 2:

Call option, VC

PV of exercise price, X

45

Expiration Date T for PT<X

and PTX
PT<X

PTX

Port. 1 Port. 2
Stock
Put

Port. 1

PT

PT

X-PT

Port. 2

Call

PT-X

Cash

Total

PT

PT
46

Put-Call Parity Relationship

Portfolio payoffs are equal, so portfolio

values also must be equal.
Put + Stock = Call + PV of Exercise Price
-rRFt

Put + P = VC + Xe

-rRFt

Put = VC P + Xe

47