FINANCE FIN2004

Lesson 12 Options

RWJLT Chapter 24

In the Headlines
The 10 Largest Trading Losses In History http://newsfeed.time.com/2012/05/11/top-10-biggest-tradinglosses-in-history/slide/all/ March 11, 2012 (and Wikipedia). Excludes Hedge Funds

Trader Name Howie Hubler Jerome Kerviel Brian Hunter Bruno Iksil John Meriwether

Loss in $Billions $9.0 $7.2 $6.5 $5.8 $4.6

Institution Morgan Stanley Societe Generale Amaranth Advisors JP Morgan Chase Long Term Capital Management

Market Credit Default Swaps European Index Futures Gas Futures Credit Default Swaps Interest Rate & Equity Derivatives

Year 2008 2008 2006 2012 1998

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In the Headlines (contd)

Trader Name Yasuo Hamanaka Isac Zagury, Rafael Sotero Kweku Adoboli Robert Citron Heinz Schimmelbusch Loss in $Billions $2.6 $2.5 Institution Sumitomo Corporation Aracruz Market Copper Futures Foreign Exchange Options Equities ETF and Delta 1 Interest Rate Derivatives Oil Futures Year 1996 2008

$2.0 $1.7 $1.3

UBS Orange County Metallgesellschaft

2011 1994 1993

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Lecture Outline
1. Derivative Securities Overview 2. Options Basics 3. Options Payoffs 4. Put-Call Parity 5. Determinants of Option Values 6. Not Examinable: Options Valuation: The Binomial Model Options Valuation: The Black-Scholes Model Options and Corporate Finance
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Derivative Securities Overview

A derivative security is one for which the ultimate payoff (or gain) to the investor depends directly on the value of another security (the underlying asset) or commodity. Types of derivatives: Options: Call Options & Put Options Forwards & Futures Extended Derivatives: Swaps / Convertible Securities / Other Embedded Derivatives (bonds with Call feature) Derivatives are useful for risk-management (e.g. an airline can use an energy derivative to hedge the risk of rising fuel prices), but they can also be use for speculation (by taking advantage of their large leverage effect).
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Derivative Securities Overview (contd)

The underlying assets of derivatives include: Agricultural commodities (corn, soybeans, wheat, (live) cattle, pork, lumber, dairy, even orange juice, etc). Energy products (crude oil, refined oil, natural gas, electricity, etc.) Metals (steel, copper, silver, gold, platinum, etc.) Currencies (Euro, Chinese Yuan, Japan Yen, S$, etc.) Stock, bonds, and indices (S&P 500, Dow Jones, Nasdaq-100, Global indices etc.) Options (Stock Options, Index Options, Futures Options, Foreign Currency Options, Interest Rate Options, etc.)
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Global Derivatives Markets: Exchange-Traded vs. Over-The-Counter

Exchange-Traded Derivatives are standardized contracts (e.g. exchange-traded options are trade in multiples of 100 options) traded on regulated exchanges that provide clearing and regulatory safeguards to investors. Main Options Exchanges in the U.S. International Securities Exchange and Chicago Board Options Exchange (makes trading easy, creates liquid secondary market). OTC (Over-The-Counter) derivatives are customized contracts provided directly by dealers to end-users or other dealers.
Visit http://www.bis.org/statistics/derstats.htm for derivative statistics.
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Options Basics
A Call Option is a security that gives its owner (or the holder of the option) the right (but not the obligation) to purchase a given asset (usually a stock) on a given date (or anytime before a given date) at a predetermined price (referred to as the Exercise Price)

European Options - can be exercised only on the expiration date. American Options - can be exercised at any time before expiration. A Put Option, in contrast to a Call Option, gives its owner the right to sell an asset on (or before) a given date at a predetermined price.
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Options Basics (contd)

Options are side bets between investors e.g. when investors trade options on common stock among themselves, these option trades do not involve the firms who issued the shares (the underlying asset) on which the options are based. If an investor sells a Call Option (or writes a Call), he allows the buyer of the Call Option to purchase the shares from him at the Exercise Price, if the Call Option buyer chooses to do so on the expiration date. If an investor sells a Put Option (or writes a Put), he allows the buyer of the Put Option to sell the shares to him at the Exercise Price, if the Put Option buyer chooses to do so on the expiration date.
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Options Basics (contd)

Option Terminology: Call Call Option Put Put Option Buy (or Long) e.g. Long a Put means Buy a Put Sell (or Short, or Write) e.g. Short a Call means Sell a Call Alternative terminologies: Exercise Price also called Strike Price Price/Value/Cost of the Option also called Premium of the Option Maturity also referred to as Expiration of the Option

There are four possible positions for option investors: (i) Buy a Call Option, (ii) Sell a Call Option (iii) Buy a Put Option, (iv) Sell a Put Option

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Options Basics (contd)

Notation used for Options discussion:
S : S0 : ST : X : r : C0 : CT : Market price of underlying asset (at any time). Market price of underlying asset today. Market price of underlying asset at maturity (options expiration date). Exercise Price or Strike Price of the option (also denoted as E). Risk-free interest rate. The price of a call option today. The price of a call option at the options expiry date.
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Payoffs (at Maturity) Call Options

Since the owner of a Call Option has the right but not the obligation to buy the share for X dollars (Exercise Price) at maturity, he will do so only if the market price of the share at maturity exceeds X dollars. When ST > X at maturity, the owner of the Call Option would exercise the option to buy the share at X and then sell it at ST in the market, hence profiting from the difference. In this case, the value (Payoff) of the Call Option is (ST X). However, if ST < X at maturity, the owner of the Call Option can buy the share at the lower market price ST. Thus, he would not exercise the Call Option, and will let the Call Option expire. The value (Payoff) of the Call Option is then ZERO.
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At Maturity Call Option Payoff & Profit vs. Market Price of Stock (for BUYER)
$
If ST > X, If ST X, Payoff = (ST X) Payoff = 0

Payoff: CT = Max{ST X, 0}

options Premium (cost of option)

450 X
Profit = Payoff Premium

ST

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At Maturity Call Option Payoff & Profit vs. Market Price of Stock (for WRITER)
$
If ST > X, If ST X, Payoff = -(ST X) Payoff = 0

X
options Premium

450

ST

Profit = Payoff + Premium

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Payoffs (at Maturity) Put Options

Since the owner of a Put Option has the right but not the obligation to sell the share for X dollars (Exercise Price) at maturity, he will do so only if the market price of the share at maturity is below X dollars. When ST < X at maturity, the owner of the Put Option would buy the share from the market at ST dollars, and then exercise the option to sell the share at X, hence profiting from the difference. In this case, the value (Payoff) of the Put Option is (X ST). However, if ST > X at maturity, the owner of the Put Option can sell the share at the higher market price ST. Thus, he would not exercise the Put Option, and will let the Put Option expire. The value (Payoff) of the Put Option is then ZERO.
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At Maturity Put Option Payoff & Profit vs. Market Price of Stock (for BUYER)
$
If ST < X, If ST > X, Payoff = (X ST) Payoff = 0

options Premium (cost of option)

450 X
Profit = Payoff Premium

ST

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At Maturity Put Option Payoff & Profit vs. Market Price of Stock (for WRITER)
$
If ST < X, If ST > X, Payoff = -(X ST) Payoff = 0

450

X
options Premium

ST

Profit = Payoff + Premium

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Payoff Descriptions
In-the-Money (holder of option will gain if option is exercised now)
A Call Option is in-the-money when the current market price of the stock is higher than the exercise price (i.e. S > X). A Put Option is in-the-money when the market price of the stock is lower than the exercise price (i.e. S < X).

At-the-Money (holder of option will neither gain nor lose if option is exercised now)
A Call Option or a Put Option is at-the-money if the market price of the stock is equal to the exercise price of the options (i.e. S = X).

Out-of-the-Money (holder of option will lose if option is exercised now)

A Call Option is out-of-the-money when the market price of the stock is lower than the exercise price (i.e. S < X). A Put Option is out-of-the-money when the market price of the stock is higher than the exercise price (i.e. S > X).

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Example 3 Different Investment Strategies: Stock, Call Options, Call Options + T-Bills
You have $10,000 to invest. You can invest in three different ways. The stock is selling for $100/share. Each Call Option (with a Strike Price of $100) is selling for $10. The risk-free rate is 3%.
Investment All Stocks All Options Calls+T-Bills Strategy Buy stock @ $100 Buy calls @ $10 Buy calls @ $10 & T-bills with 3% yield 100 shares 1,000 options 100 options T-bills Investment $10,000 $10,000 $1,000 $9,000

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Example 3 Different Investment Strategies Stock: Investment Values

Investment Value Under 3 Scenarios of Stock Price $95 All Stocks All Options Calls+T-Bills
Calls $0 T-Bills $9,270

$105 $10,500 $5,000 $9,770

Calls $1,500 T-Bills $9,270

$115 $11,500 $15,000 $10,770

$9,500 $0 $9,270
Calls $500 T-Bills $9,270

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Example 3 Different Investment Strategies: Investment Returns

Investment Return Under 3 Scenarios of IBM Stock Price $95 All Stocks All Options Calls+T-Bills -5% -100% -7.3% $105 5% -50% -2.3% $115 15% 50% 7.7%

Observation: For the same fluctuation in price of the underlying stock, the All Options strategy provides the highest returns volatility while it has the potential to achieve substantial gains (50%), it may also suffer a complete loss!
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Example 3 Different Investment Strategies: Investment Returns (contd)

All Options strategy is essentially a leveraged investment, as there is a disproportionately higher increase in return for a smaller increase in price in the underlying asset.

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Creating a payoff position using a mix of the underlying asset and its options
Any set of payoffs (that depends on the value of some underlying asset), can be constructed with a mix of simple options on that asset By adding and subtracting various combinations of Calls and Puts (at various Exercise Prices), we can create a variety of financial instruments with an endless range of payoff positions.

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Creating a Protective Put Position: Stock + Put

Buy a Stock & Buy a Put Option on the Stock Protective Put allows the investor to limit the value of his stock to a minimum of $X, while allow him to enjoy unlimited upside. Stock

Put

Stock+Put

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Profits: Protective Put vs. Stock Investment

Assuming S0 = X

Price paid to buy the Put Option

Protective Put limits investors loss to $P.

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Put-Call Parity
Consider the following two investments: Investment 1 Protective Put Buy one stock and one Put Option on of the stock with Exercise Price of $50. Investment 2 Call Option + Risk-free securities Buy a Call Option on the same stock with Exercise Price of $50 and T-bills with face value (maturity value) of $50. If we analyze the payoffs of the two investments
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Investment 1 Payoff
S < $50 Payoff = $50 Payoff = S

S $50

(i) + (ii): Stock + Put Option

$50
(i) Stock (ii) Put Option with Exercise Price of $50

$0 $50

ST
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Investment 2 - Payoff
(i) + (ii): Call Option + T-bills $
S < $50 S $50 Payoff = $50 Payoff = S

$50
(ii) T-bills with maturity value of $50 (i) Call Option with Exercise Price of $50

$0 $50
Note: T-bills and Call Option to have the same maturity date.

ST

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Put-Call Parity
Payoffs of Investment 1 and Investment 2 are identical. Value principle: When two investments have identical payoffs, they must be worth the same value (same PV). Hence: PV(Stock + Put) = PV(Call + Risk-free Security)

S0 + P = C + X / (1 + rf)T
PV of T-bills with maturity value of $X in time T (alternatively, zero-coupon bond with par value of $X)

The above equation is known as the Put-Call Parity. It relates the price of a Call to the price of the corresponding Put on the same stock. If the Put-Call Parity is violated, arbitrage opportunity would arise (i.e. one can buy the cheaper investment and sell the more expensive one simultaneously and make a riskless profit). 12-28

Put-Call Parity
Price of Price of Underlying + Put Stock Price of PV of = + Call Exercise Price

S + P = C + PV(X) P = C + PV(X) S

e.g. zero-coupon bond with par value = X

When the price of a Call Option on a stock is found, the price of the Put Option on the same stock (having the same Exercise Price and maturity date) can be computed using the above relationship.
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Call Option Value Bounds

Upper bound Call price must be less than or equal to the stock price. Lower bound Call price must be greater than or equal to the stock price minus the exercise price or zero, whichever is greater. That is, the value of a call option C0 must fall within max (S0 X, 0) < C0 < S0 If either of these bounds are violated, there is an arbitrage opportunity.
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Option Values
Intrinsic Value refers to the payoff that could be made if the option was immediately exercised. Call Options: Intrinsic value = Stock Price Exercise Price Put Options: Intrinsic value = Exercise Price Stock Price But in each of the above cases the Intrinsic Value cannot be negative (i.e. it is either ZERO or positive value). Time Value of an Option (not the same as time value of money) the Option Price (value of the option) is usually above its Intrinsic Value, the difference reflects the options time value. Most of the Time Value reflects the volatility value the volatility of the stock increases the chance of the options (whether Put or Call) getting into-the-money.
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Call Option Value before Expiration is highlighted in pink (Intrinsic Value in black)

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Determinants of Options Value

Stock Price Call: The value of a Call Option will increase if the stock price increases, because its payoff will be higher. Put: The value of a Put Option will decline if the stock price increases, because its payoff will be lower. Exercise Price Call: The value of a Call Option will decline if it has a higher Exercise Price, because its payoff will be lower. Put: The value of a Put Option will increase if it has a higher Exercise Price, because its payoff will be higher.
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Determinants of Options Value (contd)

Time to Expiration Call and Put: Both the Call Option value and the Put Option value will increase if they have longer maturity, since the underlying stock will have more time opportunity to move in favour of the option holder. Risk-Free Rate Call: The value of a Call Option will increase if the risk-free rate increases, since the present value of the Exercise Price will be lower (Note: The Exercise Price is paid only in the future, at the time when the Call Option is exercised). Put: The value of Put Option will decline if the risk-free rate increases, since the present value of the Exercise Price will be lower (Note: The exercise proceeds is received only in the future, at the time when the Put Option is exercised). 12-34

Determinants of Options Value (contd)

Volatility in Stock Price Call and Put: Both Call Option value and the Put Option value will increase if there is higher volatility in the underlying stock, since higher volatility would increase the probability of the options moving into-the-money.

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Determinants of Options Value (contd)

Call 1. Stock Price 2. Exercise Price 3. Time to Expiration 4. Risk-Free Rate 5. Volatility in Stock Price + + + + Put + + +

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Options Quotes: Example

Example of a call option quote: Below are quotes for options on biotech firm Amgens stock, as of November 2003, when Amgens closing stock price was $60:

Thus the call option which expired in April 2004 and allowed its owner to purchase a share of Amgen stock for $65, was sold for $1.95.
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Options Valuation: The Binomial Model

Non-Examinable

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Options Valuation
We cannot use the traditional discounted cash flow method (DCF) to value options. This is because DCF requires us to: (i) estimate expected future cash flows, and (ii) discount those cash flows at the opportunity cost of capital. An options expected cash flows and relevant risk impact change every time the underlying stocks price changes. Moreover, the underlying stock price changes constantly.
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Valuing an Option via an Option Equivalent

We can value an option by setting up an option equivalent by combining common stock investment and borrowing. How do we do this? First of all, note that the value of an option prior to expiration inherits the properties of its payoff upon expiration. Thus to price the option we: 1. First, calculate the options payoff upon expiration. 2. Second, we find a portfolio (via investment in common stock and borrowing) that replicates the option payoff and that can be priced. 3. Third, in arbitrage-free equilibrium, the value of this portfolio will also be the value of the option.
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Example: Valuing an Option via an Option Equivalent

Lets illustrate option pricing using a simple binomial example: A firms stock is presently selling for $50. At the exercise date, one year from now, the price of the stock may either increase to $65 or may drop to $45. The one-year riskfree rate is 12.5%. $65
$50
One year later

$45 Consider a call option with exercise price of $57. The call option payoff one year later is either CH or CL:

CH = max{65 57, 0} = $8 CL = max{45 57, 0} = $0

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Example: Valuing an Option via an Option Equivalent (contd)

Is there a portfolio invested in the stock and the risk-free asset that replicates the same payoff pattern? = number of shares in the original stock that we need to purchase (to replicate the portfolio). Also called the hedge ratio or option delta. B = the amount that is borrowed at the risk-free rate (to replicate the portfolio). Equate the combinations of and B to the call option payoff (recall that the risk-free rate is 12.5% and the exercise date is one year from now): ($65) + B(1 + 12.5%) = $8 ($45) + B(1 + 12.5%) = $0 Solving for and B give: = 0.4 B = -$16
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Example: Valuing an Option via an Option Equivalent (contd)

Note that we could equivalently find the hedge ratio as follows:
= Delta = spread of possible option prices = $8 $0 = 0.4 spread of possible stock prices $65 $45

Thus, to replicate the call options payoff, we need to: Buy 0.4 shares by paying 0.4($50) = $20. Borrow $16 to partially finance the purchase. The net cost of the portfolio that replicates the options payoff is $4. In an (arbitrage-free) equilibrium, this $4 must be the value of the call option. Implication: A call option is like a leveraged portfolio in which the purchase of a stock is partially financed with a risk-free loan.
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Delta and the Hedge Ratio

The above practice of the construction of a riskless hedge is called delta hedging. The delta of a call option is between 0 and 1. Recall from the example:

Swing in value of call $8 $0 = = = 0.4 Swing of value of underlying stock $65 $45
A call option that is deep in-the-money will have a delta of 1. The value of a call that is assumed to end in-the-money will move dollar for dollar in the same direction as the price of the underlying asset. The delta of a put option is between -1 and 0.
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Delt and Hedge Ratio (contd)

Amount of borrowing = (PV of the lower possible stock price at maturity)(Delta) From previous example: ($45/1.125)(0.4) = $16 Value of call option = (Stock Price)(Delta) Amount borrowed From previous example: ($50)(0.4) $16 = $4

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Options Valuation: The Black-Scholes Model

Non-Examinable

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The Black Scholes Model

The B&S model is based on the replication method previously discussed. Value of Call Option = Function of (S, X, , r, T) It is founded on the following main assumptions: Can buy or sell the stock at all times (no restriction on short sales). No transaction costs. Unlimited borrowing and lending at the risk-free rate. Prices evolve smoothly. Constant risk-free rate and volatility. Stock price is log-normally distributed (follows a log-normal random walk). Stocks do not pay dividends.
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The BlackScholes Formula

C = S0N(d1) Xe-rTN(d2)
PV(Exercise Price)

ln( d1 =

S0 + ) T ( r+ 1 2 ) 2 X T

d 2 = d1

Where: ln ( ) is the natural logarithm function. N (d) denotes the standard normal distribution function. probability that a random draw from a normal dist. will be less than d. T is the number of periods to exercise date. is the standard deviation per period of the stocks logarithmic return (continuously compounded). r the risk-free interest rate (continuously compounded).
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Simplified Analogy to the Simple Binomial Model

C = (S0 )N(d1 ) Xe

rT

N(d 2 )

Value of a Stock Amount = Delta call price borrowed

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Black-Scholes Formula Online

A number of ready made tools are available to enable you to compute option prices. One option price tool available on the web is at: http://www.option-price.com/index.php Inputs: Current Stock Price S (in $); Option Exercise Price X (in $); r is the annual risk-free interest rate to maturity of the option (in %); Annual Standard Deviation (in %); Time to Option Expiration T (note here the input is in days). [Includes input for dividend yield (in %) if dividends issued]. Output: Call Price C.
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Standard Normal Curve

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Call Option Example: Computing d1 and d2

S0 = $100 X = $95 r = 10% T = 0.25 year (one quarter) = 0.50 d1 = ln(S0/X) + T(r + (2/2) T1/2 d1 = ln(100/95) + 0.25(0.10 + 0.52/2) 0.5(0.251/2) = 0.43 d2 = d1 T1/2 = 0.43 0.5(0.251/2) = 0.18
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Probabilities from Normal Distribution

From Cumulative Normal Distribution Tables d N(d) 0.42 0.6628 0.43 0.6664 0.44 0.6700 Note: Interpolation may be used N (0.43) = 0.6664 to obtain values that fall between two figures d N(d) given in the table. 0.16 0.18 0.20 N (0.18) = 0.5714
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0.5636 0.5714 0.5793

Call Option Value

C = S0N(d1) Xe-rT N(d2) = (100)(0.6664) 95e-(0.10)(0 .25)(0.5714) = $13.70

Implied Volatility Using Black-Scholes and the actual price of the option, one can solve for implied volatility.

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Value of Put Option using Black-Scholes

P = Xe-rT[1 N(d2)] S0[1 N(d1)] Using the previous data: S0 = $100, r = 10%, X = $95, T = 0.25 P = 95e-(0.10)(0.25)(1 0.5714) 100(1 0.6664) = $6.35

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Alternative way to compute value of Put Option: Using Put-Call Parity

P = C + PV(X) S0 = C + Xe-rT S0 Using the example data: C = $13.70, X = $95, S0 = $100, r = 10%, T = 0.25 P = 13.70 + 95e (0.10)(0.25) 100 = $6.35
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Employee Stock Options (ESOs)

Employee Stock Options (ESOs) allow employees to purchase company stock at a fixed price. They are granted primarily for two basic reasons:
Align employee interests with owner interests. Feasible form of compensation for cash-strapped companies.

ESO Features differ from company to company, but some common ones are:
Typical expiration of 10 years. Cannot be sold or transferred unless the employee dies, then options transfer to the estate. Vesting (waiting) period during which they cannot be exercised. Employee loses the options if he leaves the company.
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Options and Corporate Finance

Non-Examinable
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Options and Corporate Finance

Common Stock (Equity) is a Call Option The stockholders have a call option on the firms assets with the strike price equal to the face value of the firms debt. If the firms assets are worth more than the debt, the option is in-the-money. Stockholders will exercise the option by paying off the debt. If the firms assets are worth less than the debt, the option expires unexercised. The company will default on its debt.
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Common Stock (Equity) as a Call Option

Similar to a call option, common stock has limited downside (the worst is zero value) but can enjoy unlimited upside.
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Options and Capital Budgeting

The Investment Timing Decision The option to wait is valuable when the economy or market is expected to be better in the future. The option to wait may actually turn a bad project into a good project. Waiting a year or two may allow the firm to capture higher cash flows.
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Options and Capital Budgeting (contd)

Managerial Options whether to modify a project after implementation. Option to expand: make project bigger if successful. Option to abandon: shut down project if things dont go as planned. Option to suspend or contract: downsize when market is weaker than expected.
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Options and Corporate Securities

Warrants Issued by the firm: gives the holder the right, but not the obligation, to purchase the common stock directly from the company at a fixed price before an expiry date. Used as sweeteners or equity kickers: warrants are sometimes issued together with privately placed bonds, public issues of bonds, and new stock issues to make the issue more attractive.
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Options and Corporate Securities (contd)

Convertible Bonds Bonds that may be converted into a fixed number of shares on or before the maturity date. The conversion option is essentially a call option on the companys stock with the strike price equal to the bond price.

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Options and Corporate Securities (contd)

Callable Bonds Similar to options, Callable Bonds grant the firm the option to retire the bonds early at a specified call price. Put Bonds Similar to options, Put Bonds grant the bondholder the option to demand repayment from the firm at specified intervals before maturity.
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Options and Corporate Securities (contd)

Insurance and loan guarantees These can be viewed as combination of the underlying asset plus a put option. If the asset declines in value, the owner of the put option (i.e. insured) exercises the option and sells the underlying asset to the seller of the put option (i.e. insurer).

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