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![Page 1: Chapter 21 Principles PrinciplesofCorporateFinance Ninth Edition Understanding Options Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies,](https://reader030.fdocuments.in/reader030/viewer/2022033022/56649e685503460f94b649d3/html5/thumbnails/1.jpg)
Chapter 21 PrinciplesPrinciples
ofof
CorporateCorporate
FinanceFinance
Ninth Edition
Understanding Options
Slides by
Matthew Will
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw Hill/Irwin
![Page 2: Chapter 21 Principles PrinciplesofCorporateFinance Ninth Edition Understanding Options Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies,](https://reader030.fdocuments.in/reader030/viewer/2022033022/56649e685503460f94b649d3/html5/thumbnails/2.jpg)
21- 2
Topics Covered
Calls, Puts and SharesFinancial Alchemy with OptionsWhat Determines Option Values?
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21- 3
Option Terminology
Put Option
Right to sell an asset at a specified exercise price on or before the exercise date.
Call Option
Right to buy an asset at a specified exercise price on or before the exercise date.
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21- 4
Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
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21- 5
OptionsTerminology
Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.)
Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time.
Call Option - The right to buy a security at a specified price within a specified time.
Put Option - The right to sell a security at a specified price within a specified time.
Option Premium - The price paid for the option, above the price of the underlying security.
Intrinsic Value - Diff between the strike price and the stock price
Time Premium - Value of option above the intrinsic value
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21- 6
OptionsTerminology
Exercise Price - (Striking Price) The price at which you buy or sell the security.
Expiration Date - The last date on which the option can be exercised.
American Option - Can be exercised at any time prior to and including the expiration date.
European Option - Can be exercised only on the expiration date.
All options “usually” act like European options because you make more money if you sell the option before expiration (vs. exercising it).
3 vs. 70-68=2
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21- 7
Genentech Stock
Option MaturityExercise
PricePrice of Call
OptionPrice of Put
Option
Dec-06 $70 $14.30 $0.7575 9.90 1.4080 6.50 2.7585 3.70 5.1090 1.90 8.70
Mar-07 $70 $15.10 $2.2075 12.20 2.6580 9.00 4.60
85 6.20 7.7090 4.10 9.46
Jan-08 $70 $20.50 $4.3075 18.0 5.780 14.9 7.385 12.0 10.490 9.9 12.7
Long term options are called 'LEAPS"
Selected prices for puts and calls September 2006
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21- 8
Option Value
The value of an option at expiration is a function of the stock price and the exercise price.
Example - Option values given a exercise price of $80
00001020ValuePut
302010000Value Call
110100908070$60PriceStock
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21- 9
Option Value
Call option value (graphic) given a $80 exercise price.
Share Price
Cal
l opt
ion
valu
e
80 95
$15
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21- 10
Option Value
Put option value (graphic) given a $80 exercise price.
Share Price
Put
opt
ion
valu
e
70 80
$10
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21- 11
Option Value
Call option payoff (to seller) given a $80 exercise price.
Share Price
Cal
l opt
ion
$ pa
yoff
80
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21- 12
Option Value
Put option payoff (to seller) given a $80 exercise price.
Share Price
Put
opt
ion
$ pa
yoff
80
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21- 13
Option Value
Call buyer profit – assume strike of $80 and option price of $9.00
Share Price
Pos
itio
n V
alue
Long call
80 89
- 9.00
Break even
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21- 14
Option Value
Put seller profit – assume strike of $80 and option price of $4.60
Share Price
Pos
itio
n V
alue
Short put
75.40 80
+4.60
Break even
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21- 15
Option Value
Masochists Strategy?- Long stock and short call
Share Price
Pos
itio
n V
alue “Silly Strategy”
Short Call
Long Stock
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21- 16
Option Value
Protective Put - Long stock and long put
Share Price
Pos
itio
n V
alue Protective Put
Long Put
Long Stock
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21- 17
Option Value
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
Pos
itio
n V
alue
Straddle
Long put Long call
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21- 18
Option Value
Components of the Option Price
1 - Underlying stock price = Ps
2 - Striking or Exercise price = S
3 - Volatility of the stock returns (standard deviation of annual returns) = v
4 - Time to option expiration = t = days/365
5 - Time value of money (discount rate) = r
6 - PV of Dividends = D = (div)e-rt
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21- 19
Time Decay Chart
Option Price
Stock Price
Option prices decline, ceribus paribus, when the time to expiration declines.
90 days to expiration
60 days to expiration
30 days to expiration
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21- 20
Option Value
Upper Limit
Stock Price
Lower Limit
(Stock price - exercise price) or 0which ever is higher
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21- 21
Option Value
The value of an option is bound, on the high end, by the value of the underlying stock. The lower bound is the value of exercising the option. In between, the major determinants are exercise price and stock price.
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21- 22
Option Value
The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceribus paribus.
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21- 23
Option Value
Similar to time decay, the value of an option will be higher when more volatility exists.
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21- 24
Web Resources
www.cboe.com
http://finance.yahoo.com
www.optionscentral.com
www.pcquote.com/
www.pmpublishing.com
Click to access web sitesClick to access web sites
Internet connection requiredInternet connection required