2201AFE Corporate FinanceWeek 13:• Options• Final Exam Revision

Readings: Chapter 20

2

Agenda Last Week Options» Key Concepts and Skills

Final Exam Comments and Revision

3

Last Lecture Dividends matter Chronology of dividend payment» Ex-dividend Date

Dividend Policy doesn’t matter (in theory)» Homemade dividends» Clientele effect» In real life – policy matters (low/high payouts)

Information content effect – signalling to the market Types of dividend policies Share repurchases, splits, reverse splits

4

Options

Chapter 20

5

1. Introduction & Financial Statements

2. Time Value of Money

3. Valuing Shares & Bonds

7. Mid-semester Exam

8. Some Lessons from Capital Market History

11. Financial Leverage & Capital Structure Policy

13. Options & Revision

9. Return, Risk & the Security Market Line

5. Making Capital Investment Decisions & Project Analysis

12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

6

Key Concepts and Skills Options: The Basics Contract characteristics Options Payoffs

7

Option Terminology Call option» Right without the obligation to BUY a specified asset at a specified

price on or before a specified date.

Put option» Right without the obligation to SELL a specified asset at a specified

price on or before a specified date.

Option premium» The price paid by the buyer/seller for the right to buy or sell an

asset.

Strike or Exercise price» The contracted price at which the underlying asset can be bought

(call) or sold (put).

8

Option Terminology Option contract counterparties: buyer and seller » An investor who SELLS the option – the option writer, holds a

SHORT position in the contract.» An investor who BUYS the option – holds a LONG position in the

contract.

Expiration date» The date at which an option expires.

European option» An option that can only be exercised on a particular date (on

expiry).

American option» An option that can be exercised at any time up to its expiry date.

9

Option Terminology Exercising the option» The act of buying or selling the underlying asset via the option

contract.

Contract size

Open Interest» Number of open positions (bought and sold) in the market place. » Provides an estimate of market liquidity, the higher the open

interest, the more liquid the market.

Interested? Read more here:http://www.asx.com.au/products/asx-grain-futures-and-options-trading-strategies.htm

10

Option Valuation ST = Share price at expiration

S0 = Share price today

C or P = Value of call/put option on expiration

C0 or P0 = Value of call/put option today

E = Exercise price on the option

11

Value of Option At the money:» Stock price equals exercise price (no profit/loss).

Out-of-the-money:» Option has no intrinsic value (make a loss).

In-the-money:» Option has intrinsic value (make a profit).

Intrinsic value:» The value of the option if exercised it immediately.• Call: Stock price – Exercise price > 0• Put: Exercise price – stock price > 0

The time premium or time value component:» The difference between the option premium and the

intrinsic value.

12

Value of Call Option (C0)

Share price (S0)

Call option value (C0)

S0 EOut of the money

S0 > EIn the money

Exercise price (E)

S0 = E At the money

45 °

Value of Call

Intrinsic ValueTime value

Upper bound = C0 S0

Lower bound = The larger of 0 or (S0 – E)

13

Value of Call and Put Option at Expiry (C & P) At time T:» If the call is in-the-money, it is worth: C = ST – E.» If the call is out-of-the-money, it is worthless: C = 0

» If the put is in-the-money, it is worth: P = E – ST.» If the put is out-of-the-money, it is worthless: P = 0

WhereST is the value of the stock at expiry (time T)E is the exercise price.C is the value of the call option at expiryP is the value of put option at expiry

14

Call Option Payoffs – for Buyer

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Call

payo

ff ($

)

Buy a ca

ll

50

Exercise price: E = $50

If share at expiration: ST = $80, ST = $20

Buyer payoff: max[ST – E,0] max[ST – E,0]

max[80-50,0]=30 max[20-50,0]=0

15

Call Option Payoffs – for Seller

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Opti

on P

ayoff

($)

Sell a call

50

Exercise price: E = $50

If share at expiration: ST = $80, ST = $20

Seller payoff: -max[ST-E,0] -max[ST-E,0]

-max[80 – 50,0] = -$30 -max[20 – 50,0] = 0

16

Call Option Profits/Losses

Exercise price: E =$50 Option premium: C0 = $10If ST = $80

Sell a callLoss = +10 +50-80 = -20

Buy a callProfit = -10 -50 + 80 = 20

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Opti

on p

ayoff

s ($

)

50–10

10

17

Put Option Payoffs – for Buyer

–20

0 20 40 60 80 100

–40

20

0

40

60

Stock price ($)

Opti

on p

ayoff

s ($

)

Buy a put

50

50

Exercise price: E = $50

If share at expiration: ST = $20, ST = $80

Buyer payoff: max[E – ST,0] max[E – ST,0]

max[50 – 20,0] = $30 max[50 – 80,0]= 0

18

Put Option Payoffs – for Seller

–20

0 20 40 60 80 100

–40

20

0

40

–50

Stock price ($)Opti

on p

ayoff

s ($

)

Sell a put

50

Exercise price: E = $50

If share at expiration: ST = $20, ST = $80

Seller payoff: -max[E – ST,0] -max[E – ST,0]

-max[50-20,0]= -$30 -max[50 – 80,0] = 0

19

Put Option Profits

–20

20 40 60 80 100

–40

20

40

60

Stock price ($)

Opti

on p

ayoff

s ($

)

Buy a putProfit = -10 - 20 + 50 = 20

Exercise price: E = $50Option premium: P0 = $10If ST = $20

–10

10

Sell a putLoss = +10 + 20 – 50 = -20

50

20

Conclusion Options are valuable financial instruments Increases upside potential Reduces or limits the downside

21

Revision Exam instructions, venue and structure How to study for the exam Additional consultation times

Course Revision Quiz Final comments

22

Exam Instructions 2.5 hours examination on (Tue) 6 November 2012 at 5.30PM» All chapters starting Week 6 (part 2) covered» No specific calculations from first half, however know the

basic concepts 10 minutes perusal» You can write during perusal on the exam paper only!

Closed Book Don’t bring the formula sheet with you! Materials allowed:» Non-Programmable Scientific calculator» English Translation Dictionary

23

Exam Venues ALVARADO, Luis Adrian – TURNER, Michael Joseph» QSAC_Track & Field Room, Qld Sport & Athletics Centre

(Ground Floor or Level 1)

VANDIEM, Matthew John – ZHU, Yulin» QSAC_Sprinters Room, Qld Sport & Athletics Centre

(Fourth Floor or Level 4) please use the lift!

QSAC Venue & Parking Map:» http://www.qsac.com.au/The-Venue/Location.aspx

» http://www.qsac.com.au/getattachment/The-Venue/Venue-Map/QSAC-Venue-Map.pdf.aspx

24

Break down on time

5.00PM – Arrive at your exam venue.

5.30PM – Perusal start (may write on exam paper only).

5.40PM – Start of Final Exam.

No one may leave in the first 30 minutes.

6.10PM – Hero to be the first to exit venue (may be zero too).

. . . . . . .

8.00PM – Last 10 minutes, no one may leave (no more toilet breaks).

8.10PM – End of Exam, pen’s down and time to study for next exam.

25

Exam Structure Question 1 is compulsory and is worth 17 marks.

All students must attempt Question 1.

Attempt any three questions from the remaining five.

Questions 2 to 6 are worth 11 marks each.

Total marks for exam = 17 + (3 × 11) = 50

Show step by step workings and formula used.

26

Exam Structure

Question 1. (a), (b), (c), (d), (e).

Answer ONLY 3 of remaining 5 questions.

Question 2. (a), (b), (c), (d).

Question 3. (a), (b), (c).

Question 4. (a), (b), (c), (d).

Question 5. (a), (b), (c).

Question 6. (a), (b), (c).

27

How to Study? Practice! Practice! Practice!» Tutorial and practice questions» Lecture examples» Chapter examples

Read Lecture Notes

Read the chapters in the text, definitions

Theory questions can be from anywhere!

28

Consultation Times Consultation during study week:» Victor Sat (Oct 27) 2-3pm N50_0.48» Victor Sun (Oct 28) 2-3pm N50_0.48» Victor Tue (Oct 30) 4.30-5.30pm N50_0.48» Scott Wed (Oct 31) 4-6pm N50_-1.07» Dong Thu (Nov 1) 3-5pm N50_1.64» Tian Fri (Nov 2) 3-5pm N50_-1.07

No appointment/booking required if you are seeing us during these times. If you cannot make it to uni, try and contact your tutor via email.

Please bring your questions during consultation, we are here to help you learn.

29

Week 6 (part 2) Chapter 9: Project Analysis and Evaluation Evaluation of NPV Estimates

» Scenario Analysis» Sensitivity Analysis» Simulation Analysis

Break-even » Accounting» Cash» Financial

Operating Leverage Other consideration in Capital Budgeting

» Managerial options» Capital rationing

30

Week 8 Chapter 10: Some Lessons from Capital Market History» How to calculate investment return» Arithmetic and Geometric Averages» How to measure risk• Variance• Standard Deviation

» Lessons from Capital Market History» Risk Premium» Risk-Return Relationship» Efficient Market Hypothesis

31

Week 9 Chapter 11: Return, Risk and the Security Market Line» Expected Return with unequal probabilities» Variance with unequal probabilities» Portfolio Expected Return» Portfolio Variance» Principle of Diversification» Systematic and Unsystematic risk» CAPM and SML» Reward-to-Risk Ratio

32

Week 10 Chapter 17: Cost of Capital» Discount rate of the firm» Target capital structure: D/E» Cost of Equity• DGM & CAPM

» Cost of Debt• YTM

» Weighted Average Cost of Capital – WACC• Unadjusted, Adjusted, use in NPV

» Flotation costs

33

Week 11 Chapter 19: Capital Structure Policy» Optimal Capital Structure» Value of the firm» Cost of capital» Capital Structure Theory – Three cases• Case I – No taxes• Case II – With taxes• Case III – With taxes and Bankruptcy Costs

» Types of Bankruptcy Costs• Direct• Indirect

34

Week 12 Chapter 18: Dividends & Dividend Policy» Irrelevance of dividend policy» Homemade Dividends» Real world factors» Information content effect – signalling » Clientele effect» Types of dividend policies• Residual, Constant Div. Growth, Constant Payout, Compromise,

DRP» Stock splits, stock dividends and repurchases

35

Week 13 Chapter 20: Options» Basic concepts• Call• Put

» Terminology» Option Payoffs• Buyer• Seller

36

Quiz Break-even analysis shows the relationship between….?

Do we use GM or AM in variance calculation?

What is Beta, Systematic or Unsystematic Risk?

What is the value of market Beta?

If an asset is undervalued, where should it be located with respect of the SML?

To maximise value of the firm, WACC should be maximised or minimised?

37

Quiz If a firm has debt and taxes, what happens to the cost of capital

as D/E increases? What case and proposition is this?

Does dividend policy matter in theory?

What happens to the share price in a reverse split?

When would you buy a call?

If the underlying share price is decreasing the put seller makes a loss or a profit?

38

Good luck for your exams!

If you have any questions, please see any of our teaching team.