Options and Corporate Finance: Basic Concepts

22-1
Chapter Twenty Two

Options and Corporate
Corporate
Finance: Basic Concepts
Finance
Ross Westerfield Jaffe
22
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson 2003 McGrawHill Ryerson Limited
22-2
Chapter Outline
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Stock Option Quotations
22.6 Combinations of Options
22.7 Valuing Options
22.8 An OptionPricing Formula
22.9 Stocks and Bonds as Options
22.10 Capital-Structure Policy and Options
22.11 Mergers and Options
22.12 Investment in Real Projects and Options
22.13 Summary and Conclusions
22-3
22.1 Options
Many corporate securities are similar to the stock
options that are traded on organized exchanges.
Almost every issue of corporate stocks and bonds
has option features.
In addition, capital structure and capital budgeting
decisions can be viewed in terms of options.

22-4
22.1 Options Contracts: Preliminaries

An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or perhaps
before) a given date, at prices agreed upon today.
Calls versus Puts
Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at some
time in the future, at prices agreed upon today. When
exercising a call option, you call in the asset.
Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you put the asset to someone.

22-5
22.1 Options Contracts: Preliminaries

Exercising the Option
The act of buying or selling the underlying asset through
the option contract.
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
The maturity date of the option is referred to as the
expiration date, or the expiry.
European versus American options
European options can be exercised only at expiry.
American options can be exercised at any time up to expiry.
22-6
Options Contracts: Preliminaries

In-the-Money
The exercise price is less than the spot price of the
underlying asset.
At-the-Money
The exercise price is equal to the spot price of the
underlying asset.
Out-of-the-Money
The exercise price is more than the spot price of the
underlying asset.

22-7
Options Contracts: Preliminaries

Intrinsic Value
The difference between the exercise price of the option
and the spot price of the underlying asset.
Speculative Value
The difference between the option premium and the
intrinsic value of the option.
Option Intrinsic + Speculative

=
Premium Value Value

22-8
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.

22-9
Basic Call Option Pricing Relationships 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.
CaT = CeT = Max[ST - E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
CaT is the value of an American call at expiry
CeT is the value of a European call at expiry

22-10
Call Option Payoffs
60
40 Buy a call
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)
-40
-60
Exercise price = $50

22-11
Call Option Payoffs
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)

Write a call
-40
-60

22-12
Call Option Profits
60
40
Buy a call
Option profits ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-20 Stock price ($)

Write a call
-40
-60
Exercise price = $50; option premium = $10

22-13
22.3 Put Options

Put options give 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.

22-14
Basic Put Option Pricing Relationships 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.
PaT = PeT = Max[E - ST, 0]

22-15
Put Option Payoffs
60
40 Buy a put
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-40
-60

22-16
Put Option Payoffs
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-40 write a put
-60

22-17
Put Option Profits
Option profits ($)
60
40
20 Write a put
10
0
0 10 20 30 40 50 60 70 80 90 100
-10
Buy a put
-20 Stock price ($)
-40
-60
Exercise price = $50; option premium = $10

22-18
22.4 Selling Options

The seller (or writer) of an The purchaser of an option has
option has an obligation. an option.
profits ($)
60
40
Buy a call
Option profitsOption
($)
20 Write a put
10
0
0 10 20 30 40 50 60 70 80 90 100
-10
Buy a put
-20 Stock price ($)
Write a call
-40
-60

22-19
Stk Exp P/C Vol Bid Ask Opint

Nortel Networks (NT) 9.35
9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279

22-20
A recent price for the stock is $9.35

9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
This option has a strike price of $8;
June is the expiration month
22-21

This makes a call option with this exercise price in-the-
money by $1.35 = $9.35 $8.
9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
Puts with this exercise price are out-of-the-money.

22-22

9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
On this day, 15 call options with this exercise price were
traded.
22-23
The holder of this CALL option can sell it for $1.95.

9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
Since the option is on 100 shares of stock, selling this option
would yield $195.
22-24

Buying this CALL option costs $2.10.

9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
Since the option is on 100 shares of stock, buying this option
would cost $210.
22-25

9 Mar C 446 0.50 0.55 2461
9 Mar P 155 0.20 0.30 841
8 June C 15 1.95 2.10 660
8 June P 35 0.55 0.65 1310
11 Sept C 11 1.10 1.25 459
11 Sept P 5 2.65 2.80 279
On this day, there were 660 call options with this exercise
outstanding in the market.
22-26
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 clients needs.

22-27
Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Value at
Protective Put strategy has
expiry
downside protection and
upside potential
$50
Buy the Buy a put with an exercise

stock price of $50
$0
Value of
$50
stock at
expiry

22-28
Protective Put Strategy Profits
Value at
expiry
$40 Buy the stock at $40
Protective Put
strategy has
downside protection
and upside potential
$0
Buy a put with

$40 $50 exercise price of
$50 for $10
-$40
Value of
stock at
expiry

22-29
Covered Call Strategy
Value at
expiry
$40 Buy the stock at $40
Covered call
$10
$0
Value of stock at expiry
$30 $40 $50
-$30 Sell a call with
-$40 exercise price of
$50 for $10

22-30
Long Straddle: Buy a Call and a Put
Value at
expiry
Buy a call with an
$40
exercise price of
$30 $50 for $10
$0
-$10
Buy a put with an
-$20
$30 $40 $50 $60 $70 exercise price of
$50 for $10
Value of
stock at
A Long Straddle only makes money if the
expiry
stock price moves $20 away from $50.

22-31
Short Straddle: Sell a Call and a Put
Value at
expiry
A Short Straddle only loses money if the stock

price moves $20 away from $50.
$20
Sell a put with exercise price of
$10 $50 for $10
$0
Value of stock at
expiry
$30 $40 $50 $60 $70
-$30
Sell a call with an
-$40 exercise price of $50 for $10

22-32
Long Call Spread
Value at
expiry Buy a call with an
exercise price of
$50 for $10
$5 long call spread

$0
-$5
-$10 Value of
stock at
$50 $60 expiry
$55
Sell a call with exercise
price of $55 for $5

22-33
Put-Call Parity
In market equilibrium, it mast be the case that option prices
rT
are set such that: C0 Xe P0 S0
Otherwise, riskless portfolios with positive payoffs exist.
Buy the
Value at Buy the stock at $40 stock at $40
expiry financed with some
Buy a call option with debt: FV = $X
an exercise price of $40
P0
Sell a put with an
$0 exercise price of $40
C0
-[$40-P0] $40 $40 C0 Value of
rT
$40-P0 stock at
($40 Xe )
-$40 $40 Xe rT expiry
22-34
22.7 Valuing Options

The last section This section considers
concerned itself with the the value of an option
value of an option at prior to the expiration
expiry. date.
A much more
interesting question.

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
Market Value, Time Value, and Intrinsic
Value for an American Call
The value of a call option C0 must fall

Profit within max (S0 E, 0) < C0 < S0.
ST
CaT > Max[ST - E, 0] -E
ST
Market Value
Time value
Intrinsic value
E ST
loss Out-of-the-money In-the-money

22-37
22.8 An OptionPricing Formula

We will start with a Then we will graduate
binomial option pricing to the normal
formula to build our approximation to the
intuition. binomial for some real-
world option valuation.

22-38
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 S1 is 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
$21.25
22-39

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
22-40

Borrow the present value of $21.25 today and buy one 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 options 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
22-41

The levered equity portfolio value today is
todays value of one share less the present value
of a $21.25 debt: $21.25
$25
(1 rf )
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
22-42
We can value the option today as

half of the value of the levered 1 $21.25
equity portfolio: C0 $25
2 (1 rf )
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
22-43
The 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
$28.75 - $21.25 = $7.50 $3.75
$25
$21.25- $21.25 = $0 $0
22-44
The 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
S0 C0 ( S1 - debt ) = portfolio C1
$28.75 - $21.25 = $7.50 $3.75
$25 $2.38
$21.25- $21.25 = $0 $0
22-45
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.

22-46
The Risk-Neutral Approach to Valuation
S(U), V(U)
q
S(0), V(0)
1- q
S(D), V(D)
We could value 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
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 S(D), V(D)
underlying 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 asset in the next period
following an up move and a down move, respectively.
22-48

S(U), V(U)
q
q V (U ) (1 q ) V ( D )
S(0), V(0)
V ( 0)
(1 rf )
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 rf ) S (0) S ( D )
A minor bit of algebra yields: q S (U ) S ( D)
22-49
Example of the Risk-Neutral Valuation of a Call:

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)
q $28.75,C(D)
$25,C(0) $21.25 $25 (1 .15)
1- q
$21.25,C(D)

22-50

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(D)
$25,C(0)
1/3
$21.25,C(D)

22-51

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

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)
C ( 0)
$2.50
$2.38 2/3 $28.75,$3.75
(1.05)
$25,$2.38
$25,C(0)
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

The Black-Scholes Model is
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.
2 N(d) = Probability that a
ln(S / E ) (r )T
2 standardized, normally
d1
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 two-state world.
22-55

Find the value of a six-month call option on Microsoft with an
exercise price of $150.
The current value of a share of Microsoft is $160.
The interest rate available in the U.S. is r = 5%.
The option maturity is six 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

Lets try our hand at using the model. If you have a calculator
handy, follow along.
First calculate d1 and d2
ln(S / E ) (r .5 2 )T
d1
T
ln(160 / 150) (.05 .5(0.30) 2 ).5
d1 0.5282
0.30 .5
Then,
d 2 d1 T 0.52815 0.30 .5 0.31602
22-57
C0 S N(d1 ) Ee rT N(d 2 )
d1 0.5282 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

22-59

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.
22-60

Levered Equity is a Put Option.
The underlying asset comprise 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.
22-61

It all comes down to put-call parity.
rT
C0 S P0 X e
Value of a Value of a Value of a

call on the
Value of risk-free
= the firm + put on the
firm firm bond
Stockholders Stockholders
position in terms position in terms
of call options of put options
22-62
22.10 Capital-Structure Policy and Options

Recall some of the agency costs of debt: they can
all be seen in terms of options.
For example, recall the incentive shareholders in
a levered firm have to take large risks.

22-63
Balance Sheet for a Company in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 ?
Fixed Asset $400 $0 Equity $300 ?
Total $600 $200 Total $600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.

22-64
Selfish Strategy 1: Take Large Risks
(Think of a Call Option)
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firms cash)

Required return is 50%
Expected CF from the Gamble = $1000 0.10 + $0 = $100

$100
NPV $200
1.50
NPV $133
22-65
Selfish Stockholders Accept Negative
NPV Project with Large Risks
Expected cash flow from the Gamble
To Bondholders = $300 0.10 + $0 = $30
To Stockholders = ($1000 - $300) 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble = $30 / 1.5 = $20
PV of Stocks With the Gamble = $70 / 1.5 = $47
The stocks are worth more with the high risk project because
the call option that the shareholders of the levered firm hold
is worth more when the volatility is increased.
22-66
22.11 Mergers and Options

This is an area rich with optionality, both in the
structuring of the deals and in their execution.

22-67
22.12 Investment in Real Projects & Options
Classic NPV calculations typically ignore the

flexibility that real-world firms typically have.
The next chapter will take up this point.

22-68

The most familiar options are puts and calls.
Put options give the holder the right to sell stock
at a set price for a given amount of time.
Call options give the holder the right to buy stock
at a set price for a given amount of time.
Put-Call parity
rT
C0 X e S P0

22-69

The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
Much of corporate financial theory can be
presented in terms of options.
1. Common stock in a levered firm can be viewed as a call
option on the assets of the firm.
2. Real projects often have hidden options that enhance
value.

Options and Corporate Finance: Basic Concepts

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22-1

Chapter Twenty Two

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22.1 Options Contracts: Preliminaries

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22.1 Options Contracts: Preliminaries

Options Contracts: Preliminaries

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Options Contracts: Preliminaries

Option Intrinsic + Speculative

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22.2 Call Options

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Basic Call Option Pricing Relationships at Expiry

At expiry, an American call option is worth the same as

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-20 Stock price ($)

Exercise price = $50

-20 Stock price ($)

Exercise price = $50

-20 Stock price ($)

Exercise price = $50; option premium = $10

22.3 Put Options

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Basic Put Option Pricing Relationships at Expiry

At expiry, an American put option is worth the

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Exercise price = $50

-40 write a put

Exercise price = $50

Exercise price = $50; option premium = $10

22.4 Selling Options

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22.5 Stock Option Quotations

Stk Exp P/C Vol Bid Ask Opint

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22.5 Stock Option Quotations

A recent price for the stock is $9.35

Stk Exp P/C Vol Bid Ask Opint

22.5 Stock Option Quotations

Puts with this exercise price are out-of-the-money.

22.5 Stock Option Quotations

Stk Exp P/C Vol Bid Ask Opint

22.5 Stock Option Quotations

The holder of this CALL option can sell it for $1.95.

Stk Exp P/C Vol Bid Ask Opint

22.5 Stock Option Quotations

Stk Exp P/C Vol Bid Ask Opint

22.5 Stock Option Quotations

Stk Exp P/C Vol Bid Ask Opint

22.6 Combinations of Options

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Buy the Buy a put with an exercise

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Buy a put with

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A Short Straddle only loses money if the stock

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Long Call Spread

$5 long call spread

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