Chapter 22

Options and Corporate Finance

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand option terminology
 Be able to determine option payoffs and profits
 Understand the major determinants of option
prices
 Understand and apply put-call parity
 Be able to determine option prices using the
binomial and Black-Scholes models

22-1
Chapter Outline
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Option Quotes
22.6 Combinations of Options
22.7 Valuing Options
22.8 An Option Pricing Formula
22.9 Stocks and Bonds as Options
22.10 Options and Corporate Decisions: Some Applications
22.11 Investment in Real Projects and Options
22-2
22.1 Options
 An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset on
(or before) a given date, at prices agreed upon today.
 Exercising the Option
 The act of buying or selling the underlying asset
 Strike Price or Exercise Price
 Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset
 Expiry (Expiration Date)
 The maturity date of the option
22-3
Options
 European versus American options
 European options can be exercised only at expiry.
 American options can be exercised at any time up to expiry.
 In-the-Money
 Exercising the option would result in a positive payoff.
 At-the-Money
 Exercising the option would result in a zero payoff (i.e.,
exercise price equal to spot price).
 Out-of-the-Money
 Exercising the option would result in a negative payoff.
22-4
22.2 Call Options
 Call options gives the holder the right,
but not the obligation, to buy a given
quantity of some asset on or before
some time in the future, at prices
agreed upon today.
 When exercising a call option, you
“call in” the asset.

22-5
Call Option Pricing at Expiry
 At expiry, an American call option is worth
the same as a European option with the same
characteristics.
 If the call is in-the-money, it is worth ST – E.
 If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the call option at expiry 22-6
Call Option Payoffs
60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50 22-7

Call Option Profits
60
Option profits ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50; option premium = $10

–40 22-8
22.3 Put Options
 Put options gives the holder the right,
but not the obligation, to sell a given
quantity of an asset on or before some
time in the future, at prices agreed
upon today.
 When exercising a put, you “put” the
asset to someone.

22-9
Put Option Pricing at Expiry
 At expiry, an American put option is
worth the same as a European option
with the same characteristics.
 If the put is in-the-money, it is worth
E – ST.
 If the put is out-of-the-money, it is
worthless.
P = Max[E – ST, 0]
22-10
Put Option Payoffs
60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50 22-11

Put Option Profits
60
Option profits ($)

40

20
10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10 22-12

Option Value
 Intrinsic Value
 Call: Max[ST – E, 0]
 Put: Max[E – ST , 0]

 Speculative Value
 The difference between the option premium and
the intrinsic value of the option.

Option Intrinsic + Speculative

=
Premium Value Value
22-13
22.4 Selling Options
 The seller (or writer) of an option has an
obligation.
 The seller receives the option premium in
exchange.

22-14
Call Option Payoffs
60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50 22-15

Put Option Payoffs
40
Option payoffs ($)

20

Sell a put
0
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

–50
22-16
Option Diagrams Revisited
Option profits ($)

40 Buy a call

Sell a call
10 Sell a put

Stock price ($)

Buy a call 40 50 60 100
–10 Buy a put

Exercise price = $50;

–40 Sell a call
option premium = $10
22-17
22.5 Option Quotes

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½

22-18
Option Quotes
This option has a strike price of $135;

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
a recent price for the stock is $138.25;
July is the expiration month. 22-19
Option Quotes
This makes a call option with this exercise price in-the-
money by $3.25 = $138¼ – $135.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Puts with this exercise price are out-of-the-money.
22-20
Option Quotes
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½

On this day, 2,365 call options with this exercise price were
traded.
22-21
Option Quotes
The CALL option with a strike price of $135 is trading for $4.75.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions. 22-22
Option Quotes
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,431 put options with this exercise price were
traded.
22-23
Option Quotes
The PUT option with a strike price of $135 is trading for $.8125.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions. 22-24
22.6 Combinations of Options
 Puts and calls can serve as the
building blocks for more complex
option contracts.
 If you understand this, you can
become a financial engineer,
tailoring the risk-return profile to
meet your client’s needs.

22-25
Protective Put Strategy (Payoffs)
Value at Protective Put payoffs
expiry

$50

Buy the
stock Buy a put with an exercise
price of $50

$0
Value of
$50
stock at
expiry 22-26
Protective Put Strategy (Profits)
Value at Buy the stock at $40
expiry
$40 Protective Put
strategy has
downside protection
and upside potential

$0

-$10
$40 $50
Buy a put with exercise price of $50
for $10
Value of
-$40 stock at
expiry 22-27
Covered Call Strategy
Value at Buy the stock at $40
expiry

$10 Covered Call strategy

$0
Value of stock at expiry

$40 $50
Sell a call with exercise price
of $50 for $10
-$30
-$40 22-28
Long Straddle
Option payoffs ($)

40 Buy a call with exercise

price of $50 for $10
30

Stock price ($)

30 40 60 70
Buy a put with exercise
price of $50 for $10
–20

$50
A Long Straddle only makes money if the stock price moves
$20 away from $50. 22-29
Short Straddle
This Short Straddle only loses money if the stock
price moves $20 away from $50.
Option payoffs ($)

20
Sell a put with exercise price of
$50 for $10
Stock price ($)
30 40 60 70
$50

–30
Sell a call with an
–40 exercise price of $50 for $10 22-30
Put-Call Parity: P0 + S0 = C0 + E/(1+ r)T
E Portfolio payoff
Portfolio value today = C0 +
(1+ r)T
Option payoffs ($)

Call

25 bond

25 Stock price ($)

Consider the payoffs from holding a portfolio
consisting of a call with a strike price of $25 and a
bond with a future value of $25. 22-31
Put-Call Parity
Portfolio payoff
Portfolio value today = P0 + S0
Option payoffs ($)

25

Stock price ($)

25
Consider the payoffs from holding a portfolio consisting
of a share of stock and a put with a $25 strike. 22-32
Put-Call Parity
Portfolio value today
Option payoffs ($)

Option payoffs ($)

Portfolio value today
E = P0 + S0
= C0 +
(1+ r)T

25 25

25 Stock price ($) Stock price ($)

25
Since these portfolios have identical payoffs, they must have
the same value today: hence
Put-Call Parity: C0 + E/(1+r)T = P0 + S0 22-33
22.7 Valuing Options
 The last section  This section
concerned itself considers the
with the value of value of an option
an option at prior to the
expiry. expiration date.
 A much more
interesting
question.
22-34
American Call
Profit ST
Option payoffs ($)

Call

25
Market Value
Time value
Intrinsic value

ST
E
Out-of-the-money In-the-money
loss
C0 must fall within max (S0 – E, 0) < C0 < S0.
22-35
Option Value Determinants
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate + –
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option C0 must fall within
max (S0 – E, 0) < C0 < S0.
The precise position will depend on these factors.
22-36
22.8 An Option Pricing Formula
 We will start with  Then we will
a binomial option graduate to the
pricing formula to normal
build our approximation to
intuition. the binomial for
some real-world
option valuation.

22-37
Binomial Option Pricing Model
Suppose a stock is worth $25 today and in one period will either
be worth 15% more or 15% less. S0= $25 today, and in one year
S1is either $28.75 or $21.25. The risk-free rate is 5%. What is the
value of an at-the-money call option?
S0 S1
$28.75 = $25×(1.15)

$25

$21.25 = $25×(1 –.15)

22-38
Binomial Option Pricing Model
1. A call option on this stock with exercise price of $25 will
have the following payoffs.
2. We can replicate the payoffs of the call option with a levered
position in the stock.
S0 S1 C1
$28.75 $3.75

$25

$21.25 $0
22-39
Binomial Option Pricing Model
Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either
$7.50 or $0.
The levered equity portfolio has twice the option’s payoff, so the
portfolio is worth twice the call option value.

S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0 22-40

Binomial Option Pricing Model
The value today of the levered equity
portfolio is today’s value of one share $21.25
$25 
less the present value of a $21.25 debt: (1  R f )

S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
22-41
Binomial Option Pricing Model
We can value the call option today 1  $21.25 
C0  $25 
2  (1  R f ) 
as half of the value of the levered
equity portfolio:

S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
22-42
Binomial Option Pricing Model
If the interest rate is 5%, the call is worth:
1 $21.25  1
C0   $25    $25  20.24   $2.38
2 (1.05)  2

C0 S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$2.38 $25

$21.25 – $21.25 = $0 $0
22-43
Binomial Option Pricing Model
The most important lesson (so far) from the
binomial option pricing model is:
the replicating portfolio intuition.
Many derivative securities can be valued by
valuing portfolios of primitive securities when
those portfolios have the same payoffs as the
derivative securities.

22-44
Delta
 This practice of the construction of a
riskless hedge is called delta hedging.
 The delta of a call option is positive.
 Recall from the example:
Swing of call $3.75  0 $3.75 1
D   
Swing of stock $28.75  $21.25 $7.5 2
• The delta of a put option is negative.

22-45
Delta
 Determining the Amount of Borrowing:
1 $21.25  1
C0   $25    $25  $20.24   $2.38
2 (1.05)  2
Value of a call = Stock price × Delta
– Amount borrowed
$2.38 = $25 × ½ – Amount borrowed
Amount borrowed = $10.12

22-46
The Risk-Neutral Approach
S(U), V(U)
q

S(0), V(0)

1- q
S(D), V(D)

We could value the option, V(0), as the value of the

replicating portfolio. An equivalent method is risk-neutral
valuation: q  V (U )  (1  q)  V ( D)
V (0) 
(1  R f ) 22-47
The Risk-Neutral Approach
S(U), V(U)
q
q is the risk-neutral
S(0), V(0) probability of an
“up” move.
1- q
S(0) is the value of the underlying S(D), V(D)
asset today.
S(U) and S(D) are the values of the asset in the next period
following an up move and a down move, respectively.
V(U) and V(D) are the values of the option in the next period
following an up move and a down move, respectively.
22-48
The Risk-Neutral Approach
S(U), V(U)
q
q  V (U )  (1  q)  V ( D)
V (0) 
S(0), V(0)
(1  R f )
1- q
S(D), V(D)

 The key to finding q is to note that it is already impounded

into an observable security price: the value of S(0):
q  S (U )  (1  q)  S ( D)
S (0) 
(1  R f )
(1  R f )  S (0)  S ( D)
A minor bit of algebra yields: q 
S (U )  S ( D) 22-49
Example of Risk-Neutral Valuation
Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. The risk-free rate is
5%. What is the value of an at-the-money call option?
The binomial tree would look like this:
$28.75  $25  (1.15)

$28.75,C(U)
q
$25,C(0) $21.25  $25  (1  .15)

1- q $21.25,C(D)
22-50
Example of Risk-Neutral Valuation
The next step would be to compute the risk neutral
probabilities
(1  R f )  S (0)  S ( D)
q
S (U )  S ( D)
(1.05)  $25  $21.25 $5
q  2 3
$28.75  $21.25 $7.50

2/3 $28.75,C(U)

$25,C(0)

1/3
$21.25,C(D)
22-51
Example of Risk-Neutral Valuation
After that, find the value of the call in the up
state and down state.
C (U )  $28.75  $25

2/3 $28.75, $3.75

$25,C(0) C ( D )  max[$ 25  $28.75,0]

1/3
$21.25, $0
22-52
Example of Risk-Neutral Valuation
Finally, find the value of the call at time 0:
q  C (U )  (1  q)  C ( D)
C (0) 
(1  R f )

2 3  $3.75  (1 3)  $0
C (0) 
(1.05)

$2.50 2/3 $28.75,$3.75

C ( 0)   $2.38
(1.05)
$25,C(0)
$25,$2.38

1/3
$21.25, $0 22-53
Risk-Neutral Valuation and the
Replicating Portfolio
This risk-neutral result is consistent with valuing the
call using a replicating portfolio.

2 3  $3.75  (1 3)  $0 $2.50
C0    $2.38
(1.05) 1.05

1 $21.25  1
C0   $25    $25  20.24   $2.38
2 (1.05)  2

22-54
The Black-Scholes Model
C0  S  N(d1 )  Ee  Rt  N(d 2 )
Where
C0 = the value of a European option at time t = 0
R = the risk-free interest rate.
σ2 N(d) = Probability that a
ln( S / E )  ( R  )t standardized, normally
d1  2
 t distributed, random
variable will be less than
d 2  d1   t or equal to d.
The Black-Scholes Model allows us to value options in the
real world just as we have done in the 2-state world. 22-55
The Black-Scholes Model
Find the value of a six-month call option on Hardcraft,
Inc. with an exercise price of $150.
The current value of a share of Hardcraft is $160.
The interest rate available in the U.S. is R = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the
option is $10—our answer must be at least that amount.

22-56
The Black-Scholes Model
Let’s try our hand at using the model. If you
have a calculator handy, follow along.
First calculate d1 and d2
ln( S / E )  ( R  .5σ 2 )t
d1 
 t
ln( 160 / 150)  (.05  .5(0.30) 2 ).5
d1   0.52815
0.30 .5
Then,
d 2  d1   t  0.52815  0.30 .5  0.31602
22-57
The Black-Scholes Model
 Rt
C0  S  N(d1 )  Ee  N(d 2 )
d1  0.52815 N(d1) = N(0.52815) = 0.7013
d 2  0.31602 N(d2) = N(0.31602) = 0.62401

C0  $160  0.7013  150e .05.5  0.62401

C0  $20.92

22-58
22.9 Stocks and Bonds as Options
 Levered equity is a call option.
 The underlying asset comprises the assets of the firm.
 The strike price is the payoff of the bond.
 If at the maturity of their debt, the assets of the
firm are greater in value than the debt, the
shareholders have an in-the-money call. They will
pay the bondholders and “call in” the assets of the
firm.
 If at the maturity of the debt the shareholders have
an out-of-the-money call, they will not pay the
bondholders (i.e. the shareholders will declare
bankruptcy) and let the call expire.
22-59
Stocks and Bonds as Options
 Levered equity is a put option.
 The underlying asset comprises the assets of the firm.
 The strike price is the payoff of the bond.
 If at the maturity of their debt, the assets of the
firm are less in value than the debt, shareholders
have an in-the-money put.
 They will put the firm to the bondholders.
 If at the maturity of the debt the shareholders have
an out-of-the-money put, they will not exercise the
option (i.e. NOT declare bankruptcy) and let the
put expire. 22-60
Stocks and Bonds as Options
 It all comes down to put-call parity.
E
C0 = S0 + P0 –
(1+ R)t
Value of a Value of a Value of a
Value of
call on the = the firm + put on the – risk-free
firm firm bond

Stockholder’s Stockholder’s
position in terms position in terms
of call options of put options 22-61
Mergers and Diversification
 Diversification is a frequently mentioned reason for
mergers.
 Diversification reduces risk and, therefore, volatility.
 Decreasing volatility decreases the value of an option.
 Assume diversification is the only benefit to a merger:
 Since equity can be viewed as a call option, should the merger
increase or decrease the value of the equity?
 Since risky debt can be viewed as risk-free debt minus a put
option, what happens to the value of the risky debt?
 Overall, what has happened with the merger and is it a good
decision in view of the goal of stockholder wealth
maximization?
22-62
Example
 Consider the following two merger candidates.
 The merger is for diversification purposes only with no
synergies involved.
 Risk-free rate is 4%.
Company A Company B
Market value of assets $40 million $15 million
Face value of zero $18 million $7 million
coupon debt
Debt maturity 4 years 4 years
Asset return standard 40% 50%
deviation
22-63
Example
 Use the Black and Scholes OPM (or an options
calculator) to compute the value of the equity.
 Value of the debt = value of assets – value of equity

Company A Company B
Market Value of Equity 25.72 9.88
Market Value of Debt 14.28 5.12

22-64
Example
 The asset return standard deviation for the combined firm is 30%
 Market value assets (combined) = 40 + 15 = 55
 Face value debt (combined) = 18 + 7 = 25

Combined Firm

Market value of equity 34.18

Market value of debt 20.82

Total MV of equity of separate firms = 25.72 + 9.88 = 35.60
Wealth transfer from stockholders to bondholders = 35.60 – 34.18 = 1.42
(exact increase in MV of debt)
22-65
M&A Conclusions
 Mergers for diversification only transfer
wealth from the stockholders to the
bondholders.
 The standard deviation of returns on the assets
is reduced, thereby reducing the option value
of the equity.
 If management’s goal is to maximize
stockholder wealth, then mergers for reasons
of diversification should not occur.
22-66
Options and Capital Budgeting
 Stockholders may prefer low NPV projects to high
NPV projects if the firm is highly leveraged and the
low NPV project increases volatility.
 Consider a company with the following
characteristics:
 MV assets = 40 million
 Face Value debt = 25 million
 Debt maturity = 5 years
 Asset return standard deviation = 40%
 Risk-free rate = 4%
22-67
Example: Low NPV
 Current market value of equity = $22.706 million
 Current market value of debt = $17.294 million
Project I Project II
NPV $3 $1
MV of assets $43 $41
Asset return standard 30% 50%
deviation
MV of equity $23.831 $25.381
MV of debt $19.169 $15.169
22-68
Example: Low NPV
 Which project should management take?
 Even though project B has a lower NPV, it is
better for stockholders.
 The firm has a relatively high amount of
leverage:
 With project A, the bondholders share in the NPV
because it reduces the risk of bankruptcy.
 With project B, the stockholders actually
appropriate additional wealth from the
bondholders for a larger gain in value.
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Example: Negative NPV
 We have seen that stockholders might prefer a
low NPV to a high one, but would they ever
prefer a negative NPV?
 Under certain circumstances, they might.
 If the firm is highly leveraged, stockholders
have nothing to lose if a project fails, and
everything to gain if it succeeds.
 Consequently, they may prefer a very risky
project with a negative NPV but high potential
rewards.
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Example: Negative NPV
 Consider the previous firm.
 They have one additional project they are
considering with the following characteristics
 Project NPV = -$2 million
 MV of assets = $38 million
 Asset return standard deviation = 65%

 Estimate the value of the debt and equity

 MV equity = $25.453 million
 MV debt = $12.547 million
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Example: Negative NPV
 In this case, stockholders would actually prefer
the negative NPV project to either of the
positive NPV projects.
 The stockholders benefit from the increased
volatility associated with the project even if
the expected NPV is negative.
 This happens because of the large levels of
leverage.

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Options and Capital Budgeting
 As a general rule, managers should not accept
low or negative NPV projects and pass up high
NPV projects.
 Under certain circumstances, however, this
may benefit stockholders:
 The firm is highly leveraged
 The low or negative NPV project causes a
substantial increase in the standard deviation of
asset returns
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22.11 Investment in Real Projects and Options
 Classic NPV calculations generally ignore
the flexibility that real-world firms
typically have.
 Option to expand
 Option to abandon

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Quick Quiz
 What is the difference between call and put options?
 What are the major determinants of option prices?
 What is put-call parity? What would happen if it does
not hold?
 What is the Black-Scholes option pricing model?
 How can equity be viewed as a call option?
 Should a firm do a merger for diversification
purposes only? Why or why not?
 Should management ever accept a negative NPV
project? If yes, under what circumstances?

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