Corporate Finance

OPTIONS

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 Option - Basic Concept

• Options: An instrument that provides its holder with an

opportunity to purchase or sell a specified asset at a stated price
on or before a set expiration date.

• The stock that the option holder has the right to buy is called the
underlying asset and the option derives its value from the value
of its underlying stock. Hence, it is called derivatives.

• Strike price: The price at which the holder of a call option can
buy (or the holder of a put option can sell) a specified amount of
stock at any time prior to the option’s expiration date.

• European Call: Can be exercised only at maturity.

• American Call: Can be exercised on or at any time before maturity

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 Option - Basic Concept

• Call Option: An option to purchase a specified no. of shares of a stock

on or before a specified future date a stated price.

• In case of buying a Call Option: If the stock price is less than the strike
price on maturity, option of call won’t be exercised.

Value of call option at expiration = market price (St) – exercise price (E)

• Put Option: An option to sell a specified no. of shares of a stock on or

before a specified future date a stated price.

• In case of buying a Put Option: If the stock price is more than the
strike price on maturity, put option won’t be exercised

Value of put option at expiration = exercise price (E) – market price (St)

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 Option Payoff

• BUY CALL (LONG CALL):

1. Outflow strategy – Payment of Premium/cost

2. Right to Buy
3. Unlimited Upside; Limited Downside
4. Normally not wanting to invest : Wait and Watch
5. View : Price will go up
6. Profit when price will go up.

Profit

Exercise Price

Share Price
Premium Paid

Loss
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 Option Payoff

• Call Option Holder (Buyer)

• Exercise Price : Rs. 105
• Premium : Rs. 5

Share Price (St) 100 105 110 115 120

Exercisability of Call Option Lapse Lapse Exercise Exercise Exercise

Value of Call Option 0 0 5 10 15

[Max (St - E,0)]
Cash Inflow – Share Price - - 110 115 120
(Sale of Share in the market
at CMP)
Cash Outflow – Premium Paid 5 5 5 5 5

Cash Outflow – Exercise - - 105 105 105

Price
Net Pay-Off (1)-(2)-(3) -5 -5 0 +5 +10
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 Option Payoff

• SELL CALL (SHORT CALL):

1. Inflow strategy – Receipt of Premium/Income
2. Obligation to Sell
3. Unlimited Downside; Limited Upside
4. Normally holding an asset, Earning Income and if price goes up and option
exercised ; sell/deliver own holding
5. View : Price will fall down
6. Loss when price will go up.

Profit
Premium
Received Exercise Price

Share Price

Loss
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 Option Payoff

• Call Option Writer (Seller)

• Exercise Price : Rs. 105
• Premium : Rs. 5

Share Price (St) 100 105 110 115 120

Exercisability of Call Option Lapse Lapse Exercise Exercise Exercise

Cash Inflow – Exercise Price - - 105 105 105

Cash Inflow – Premium 5 5 5 5 5

Received
Cash Outflow – Share Price - - 110 115 120
(Purchase of Share from
Market at CMP)
Net Pay-Off (1)+(2)-(3) +5 +5 0 -5 -10

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 Option Payoff

• BUY PUT (LONG PUT):

1. Outflow strategy – Payment of Premium/cost

2. Right to Sell
3. Unlimited Upside; Limited Downside
4. Normally Protecting Investment, Owning the asset
5. View : Price will fall down
6. Profit when price will fall down.

Profit

Exercise Price

Share Price
Premium Paid

Loss
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 Option Payoff

• Put Option Holder (Buyer)

• Exercise Price : Rs. 30
• Premium : Rs. 5
Share Price (St) 18 25 28 30 40
Exercisability of Put Option Exercise Exercise Exercise Lapse Lapse

Value of Put Option 12 5 2 0 0

[Max (E - St,0)]
Cash Inflow – Exercise Price 30 30 30 - -
(Sale of Share to the seller at
exercise price)
Cash Outflow – Premium Paid 5 5 5 5 5

Cash Outflow – Share Price 18 25 28 - -

(Purchase of Share from the
market at CMP)
Net Pay-Off (1)-(2)-(3) 7 0 -3 -5 -5
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 Option Payoff

• SELL PUT (SHORT PUT):

1. Inflow strategy – Receipt of Premium/Income

2. Obligation to Buy
3. Unlimited Downside; Limited Upside
4. Opportunity to invest
5. View : Price will go up
6. Loss when price will fall down.

Profit
Premium
Received
Exercise Price

Share Price

Loss
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 Option Payoff

• Put Option Seller (Writer)

• Exercise Price : Rs. 30
• Premium : Rs. 5

Share Price (St) 18 25 28 30 40

Exercisability of Put Option Exercise Exercise Exercise Lapse Lapse

Cash Inflow – Share Price 18 25 28 - -

(Sale of Share in the market
at CMP)
Cash Inflow – Premium 5 5 5 5 5
Received
Cash Outflow – Exercise 30 30 30 - -
Price (Purchase of Share
from the holder at exercise
price)
Net Pay-Off (1)+(2)-(3) -7 0 3 5 5
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 Option Payoff

BUY CALL SELL CALL

BUY PUT SELL PUT

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 PUT-CALL PARITY

• Relationship among share price, call and put values and the present
value of exercise price

Value of call + present value of exercise price = value of put + share price

• It can be expressed in several ways. Twisting the formula,

Value of Put = Value of call + present value of exercise price – share price

Interpretation :
Buy Put
Is identical to

Buy call, invest present value of exercise price in safe asset, sell share

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 FACTORS DETERMINING OPTION VALUE

1. Exercise Price and Share Price (Price of Underlying Asset)

2. Volatility of returns on share
3. Time to expiration
4. Interest Rate

Principles for value of options:

• Value of an option increases as stock increases

• Value of an option increases with both the rate of interest and

time to maturity

• Value of an option increases with volatility of share price and

time to maturity
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OPTION VALUE

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