Corporate Finance

Lecture 6: Introduction to Options

Tak-Yuen Wong

Department of Quantitative Finance

National Tsing Hua University
Motivating Examples

Examples:
▶ In 2004 Air France acquires the Dutch airline, KLM, in exchange for a
package of Air France shares and warrants. The warrants entitle KLM’s
shareholders to buy additional Air France shares for €20 each within then
next 3.5 years
▶ In February 2008 Chiquita Brands issues $200 million of 4.25%
convertible bonds maturing in 2016. Each bond can be exchanged for
44.55 shares at any time before maturity
▶ The coffee roaster, Green Mountain, buys options that put a ceiling on
the price that it will pay for its future purchases of beans
Commonality:
▶ Companies have the flexibility to trade certain financial securities or
commodities at prespecified price in the future
▶ Flexibility is embedded in these financial options, investors do not need
to commit to the conversion
What About Real Investment?

▶ Amgen, a global biotech company, spent 20% of its revenues on research

and development (R&D). Drug development often takes very long time
and a lot of experimentation, and only a very small number of early-stage
drugs developed can ultimately reach the market. How should Amgen
value its R&D project?
▶ The company always has flexibility in control the inputs:
▶ If early-stage research results are favorable, continue to the next
stage and commit additional capital
▶ If research results are not promising, should stop funding
▶ Flexibility in decision making and information accumulates over time
Real Options

▶ Real options: the right to make a particular business decision.

▶ Examples: oil field explorations, real estate developments, movie
productions, mergers and acquisitions, R&D experimentation
▶ Important options in capital investment include
▶ The option to wait before investment
▶ The option to make follow up investment
▶ The option to vary production scale
▶ The option to abandon a project
▶ Two key characteristics underlie real options:
1. New information arrives over time
2. Decisions can be made based on new information, and decisions are
sometimes difficult to reverse
▶ How do we value options?
Financial Options: Some Definitions

▶ A financial option gives its owner the right but not the obligation to buy
or sell an underlying financial asset at a specified exercise or strike price
on or before a specified expiration or maturity date.
▶ Only pay the exercise price until you decide to exercise the option
▶ Types of options
▶ Call option: right to buy vs. Put option: right to sell
▶ American option: exercise at any time up to the expiration date vs.
European option: exercise only at the expiration date
▶ Summary:

When can the holder exercise the right?

only at expiration any time before expiration
buy European Call American Call
Right to...
sell European Put American Put

▶ We focus on European stock options

Financial Options: Example
▶ Prices of put and call options on Google stock in September 2008, when the
closing stock price was $430.

1. In general, the value of a call option goes down as the exercise price goes up
2. Option price increases as option maturity is extended
Payoffs at Expiration

▶ Value of European options at expiration with an exercise price of K = $430 as a

function of market price of the share S at the expiration date

▶ The value of a call = max{S − K , 0}. Say, S = $600 > K = $430, can buy the
share at the lower exercise price. Payoff: 600 − 430 = $170.
▶ The value of a put = max{K − S, 0}. Say S = $300 < K = $430, can sell the
share at the higher exercise price. Payoff: 430 − 300 = $130.
Payoffs of Selling Calls and Puts
▶ Previous payoffs are for holders of the call or put. An investor who sells a call
(put) promises to sell (buy) a share to the call (put) buyer at the pre-specified
exercise price

▶ At S = $600 > K = $430, call buyer exercises her right to buy and call seller is
obligated to sell. Call seller’s payoff: 430 − 600 = −$170.
▶ At S = $300 < K = $430, put buyer exercises her right to sell and put seller is
obligated to buy. Put seller’s payoff: 300 − 430 = −$130.
Payoffs are not Profits

▶ Payoffs diagrams show only the payoffs at option exercise

▶ They do not account for the initial cost of buying the option or the initial
proceeds from selling it
▶ Too good for call/put buyers: payoffs are always positive
▶ Call price is $54.35 and put price is $48.55 from the table.

▶ Both call buyer and put seller lose if the share price is not high enough
Alchemy with Options

▶ Payoff of buying a stock at $430 is a 45-degree line

▶ Investment strategy involving options can retain the upside potential of

stock holding but gives complete downside protection
▶ Payoff stays at $430 even the stock price falls below
Creating Downside Protection
▶ Buy a share and a put option with exercise price equals the current market
price of the share
▶ Idea: when the price falls, payoff from exercising the put option covers the
loss in the stock investment

▶ Investment strategy involving a put option can retain the upside potential
of stock holding but gives complete downside protection
▶ Payoff stays at $430 even the stock price falls below
An Equivalent Investment Strategy
▶ Interestingly, you can create the same payoff using different instruments
▶ Say, depositing an amount such that the repayment is $430 and buy a call
option

▶ The bank deposit naturally gives you the downside protection, and the call
option allows you to capture the upside gain when the stock price goes up
▶ Payoff again stays at $430 even the stock price falls below
Put-Call Parity

▶ Regardless of the future stock price, two different investment strategies

involving a put and a call provide identical payoffs:
1. Buy call, invest present value of exercise price in safe asset
2. Buy put, buy share
▶ Put-call parity: the fundamental relationship for European options:

value of call + PV (exercise price) =value of put + share price

▶ What about American options?

▶ Put–call parity holds only if you are committed to holding the
options until the final exercise date
▶ American options can be exercised before the final date, so the parity
does not hold
What Determines Option Values?

▶ So far, we are focusing on the payoffs of options at expiration date. How

the market value of an option is determined?
▶ The price of an option depends on the current share price

▶ Dashed line is the value of a call before its expiration date

▶ It is always worth more than its value if exercised now (heavy line)
▶ It is never worth more than the stock price itself (upper bound)
Point A: Current Price is Zero

▶ Point A: When the stock is worthless, the option is sure to expire

unexercised and worthless
▶ Stock price of zero means that there is no possibility the stock will ever
have any future value
▶ Then, the option is sure to expire unexercised and worthless, and it is
worthless today.
Point B: Current Price is High

▶ Point B: When the stock price becomes large, the option price
approaches the stock price less the present value of the exercise price
▶ The higher the stock price, the higher is the probability that the option will
eventually be exercised.
▶ Effectively owns the stock now but pay the price later when a formal
exercise occurs
Point C: Current Price equals Exercise Price

▶ Point C: The option price always exceeds its minimum value (except
when stock price is zero)
▶ At this point, the stock price exactly equals the exercise price. The option
is therefore worthless if exercised today
▶ But suppose today is not the expiration date, the volatility of share price
drives the value of option
The Effect of Stock Price Volatility

▶ Both the prices of firm X and Y’s shares are equal to the exercise price
▶ Firm Y is more volatile, and it has a greater upside potential
▶ What about the downside? In the worst case, don’t exercise the
option
▶ Same as the risk-shifting logic in the argument for the costs of financial
distress
Fundamental Results of Option Valuations

▶ The value of a call option ...

1. increases if stock price increases, or if the exercise price decreases
2. increases with both the rate of interest and the time to maturity
3. increases with the volatility of the share price
▶ Flexibility of decision making implies the current option value is greater
than the payoff at expiration
▶ Next: a formal approach for option valuations