2201AFE Corporate Finance

Week 13: Options Final Exam Revision

Readings: Chapter 20

Agenda
Last Week Options
Key Concepts and Skills

Final Exam Comments and Revision

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

Dividend Policy doesnt 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
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Options

Chapter 20

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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Key Concepts and Skills

Options: The Basics Contract characteristics Options Payoffs

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).
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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. (See more here: http://www.asx.com.au/products/futures-options-expiry-calendars.htm)

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.
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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

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

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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.
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Value of Call Option (C0)

Upper bound = C0 S0

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

Call option value (C0)

Value of Call Time value

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Intrinsic Value
Share price (S0) S0 > E In the money

Exercise price (E) S0 E Out of the money

S0 = E At the money

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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
Where

ST is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry P is the value of put option at expiry
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Call Option Payoffs for Buyer

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Call payoff ($)

40

20

20 20

40

50

60

80

100

120 Stock price ($)

Exercise price: E = $50 If share at expiration: ST = $80, max[ST E,0] max[80-50,0]=30 ST = $20 max[ST E,0] max[20-50,0]=0
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Buyer payoff:

Call Option Payoffs for Seller

60 Exercise price: E = $50 If share at expiration: 40 Option Payoff ($) Seller payoff: ST = $80, -max[ST-E,0] -max[80 50,0] = -$30 20 ST = $20 -max[ST-E,0] -max[20 50,0] = 0

20 20

40

50

60

80

100

120 Stock price ($)

40
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Call Option Profits/Losses

60 Option payoffs ($)

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

Buy a call Profit = -10 -50 + 80 = 20

20 10 20 10 20 40 50 60 80 100 120 Stock price ($)

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Sell a call Loss = +10 +50-80 = -20

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Put Option Payoffs for Buyer

60 Option payoffs ($) 50 40

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Buy a put
0 20 40 50 60 80 100 Stock price ($)

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Exercise price: E = $50 If share at expiration: ST = $20, ST = $80 max[E ST,0] max[50 80,0]= 0
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Buyer payoff:

max[E ST,0] max[50 20,0] = $30

Put Option Payoffs for Seller

40 Option payoffs ($) Exercise price: E = $50 If share at expiration: Seller payoff: 20 ST = $20, -max[E ST,0] -max[50-20,0]= -$30 ST = $80 -max[E ST,0] -max[50 80,0] = 0

Sell a put
0 20 40

50

60

80

100

Stock price ($)

20

40 50

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Put Option Profits

60 Option payoffs ($)

40

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

Sell a put Loss = +10 + 20 50 = -20

20

10
Stock price ($) 10 20 20 40 50 60 80 100

Buy a put Profit = -10 - 20 + 50 = 20

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

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Revision
Course Revision Recap in more details the chapters Quiz Exam instructions, venue and structure

How to study for the exam

Additional consultation times Final comments

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Week 5 (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
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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
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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
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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
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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 and Indirect
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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

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Week 13
Chapter 20: Options
Basic concepts
Call Put

Terminology Option Payoffs

Buyer Seller

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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?
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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?

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Exam Instructions
2.5 hours examination on (Thursday) 20 June 2013 at 8.30AM
All chapters starting Week 5 (part 2) covered No specific calculations from first half, however know the basic concepts

10 minutes perusal
During perusal, you can only write on the exam paper!

Closed Book
Dont bring the formula sheet with you!

Materials allowed:
Non-Programmable Scientific calculator English Translation Dictionary
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Exam Venues
QSAC_Track & Field Room, Qld Sport & Athletics Centre (Ground Floor or Level 1) QSAC Venue & Parking Map:
http://www.qsac.com.au/The-Venue/Location.aspx

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

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Break down on time

8.00AM Arrive at your exam venue. 8.30AM Perusal start (may write on exam paper only). 8.40AM Start of Final Exam. No one may leave in the first 30 minutes.

9.10AM Hero to be the first to exit venue (may be zero too).

....... 11.00AM Last 10 minutes, no one may leave (no more toilet breaks). 11.10AM End of Exam, pens down and time to study for next exam.

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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.

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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).

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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!
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Consultation Times
Consultation during study week:
Please check Learning@GU under Announcement for more details.

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.

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Good luck for your exams!

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

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