Chap 022

Chapter
22
Options and Corporate Finance
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
Understand option terminology

Be able to determine option payoffs and profits
Understand the major determinants of option
prices
Understand and apply put-call parity
Be able to determine option prices using the
binomial and Black-Scholes models
22-2
Chapter Outline
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Option Quotes
22.6 Combinations of Options
22.7 Valuing Options
22.8 An Option Pricing Formula
22.9 Stocks and Bonds as Options
22.10 Options and Corporate Decisions: Some Applications
22.11 Investment in Real Projects and Options
22-3
22.1 Options
An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or before) a
given date, at prices agreed upon today.
Exercising the Option
Strike Price or Exercise Price
The act of buying or selling the underlying asset

Refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset
Expiry (Expiration Date)
The maturity date of the option

22-4
Options
European versus American options
In-the-Money
Exercising the option would result in a positive payoff.
At-the-Money
European options can be exercised only at expiry.

American options can be exercised at any time up to expiry.
Exercising the option would result in a zero payoff (i.e., exercise

price equal to spot price).
Out-of-the-Money
Exercising the option would result in a negative payoff.

22-5
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.
22-6
Call Option Pricing 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:
C = Max[ST E, 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
22-7
al
Call Option Payoffs

ac
Bu
y
Option payoffs ($)
60
40
20
20
40
50
60
80
100
120
Stock price ($)
20
40
Exercise price = $50
22-8
Call Option Profits

Option profits ($)
60
Buy a call
40
20
10
20
10
40
50 60
80
100
120
Stock price ($)
20
40
Exercise price = $50; option premium = $10

22-9
22.3 Put Options
Put options gives 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.
22-10
Put Option Pricing 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
S T.
If the put is out-of-the-money, it is
worthless.
P = Max[E ST, 0]
22-11
Put Option Payoffs

Option payoffs ($)
60
50
40
20
20
40
50
60
80
100
Buy a put
Stock price ($)
20
40
22-12
Put Option Profits

Option profits ($)
60
40
20
10
10
20
40 50 60
80
100
Stock price ($)
Buy a put
20
40
Exercise price = $50; option premium = $10
22-13
Option Value
Intrinsic
Value
Call: Max[ST E, 0]
Put: Max[E ST , 0]
Speculative
Value
The difference between the option premium and the intrinsic

value of the option.
Option
Premium
Intrinsic
Value
Speculative
+
Value
22-14
22.4 Selling Options
The seller (or writer) of an option has an

obligation.
The seller receives the option premium in
exchange.
22-15
Call Option Payoffs

Option payoffs ($)
60
40
20
20
40
50
60
80
100
120
Stock price ($)
20
Se
ll
l
al
ac
40
22-16
Put Option Payoffs

Option payoffs ($)
40
20
Sell a put
0
20
40
50
60
80
100
Stock price ($)
20
40
50
22-17
40
Buy a call
y
Bu
ap
ut
Option profits ($)
Option Diagrams Revisited
10
10
Sell a call
Buy a call
ll
e
S
40
Sell a put
40
50 60
100
Stock price ($)

Buy a put
ut
p
a
Exercise price = $50;

option premium = $10
Sell a call
22-18
22.5 Option Quotes

Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug
--Call---Put-Vol. Last Vol. Last

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
22-19
Option Quotes
This option has a strike price of $135;
Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
a recent price for the stock is $138.25;

July is the expiration month.
22-20
Option Quotes
This makes a call option with this exercise price in-themoney by $3.25 = $138 $135.
--Call---Put-Option/Strike Exp. Vol. Last Vol. Last
IBM
130 Oct
364 15
107
5
138
130 Jan
112 19
420
9
138
135 Jul
2365
4 2431 13/16
138
135 Aug 1231
9
94
5
138
140 Jul
1826
1
427
2
138
140 Aug 2193
6
58
7
Puts with this exercise price are out-of-the-money.
22-21
Option Quotes
Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
On this day, 2,365 call options with this exercise price were
traded.
22-22
Option Quotes
The CALL option with a strike price of $135 is trading for $4.75.
Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
Since the option is on 100 shares of stock, buying this option

would cost $475 plus commissions.
22-23
Option Quotes
Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
On this day, 2,431 put options with this exercise price were
traded.
22-24
Option Quotes
The PUT option with a strike price of $135 is trading for $.8125.
Option/Strike Exp.
IBM
130 Oct
138
130 Jan
138
135 Jul
138
135 Aug
138
140 Jul
138
140 Aug

364 15
107
5
112 19
420
9
2365
4 2431 13/16
1231
9
94
5
1826
1
427
2
2193
6
58
7
Since the option is on 100 shares of stock, buying this

option would cost $81.25 plus commissions.
22-25
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.
22-26
Protective Put Strategy (Payoffs)

Value at
expiry
Protective Put payoffs
$50
Buy the
stock
Buy a put with an exercise

price of $50
$0
$50
Value of
stock at
expiry
22-27
Protective Put Strategy (Profits)

Value at
expiry
Buy the stock at $40
$40
Protective Put
strategy has
downside protection
and upside potential
$0
-$10
-$40
$40 $50
Buy a put with exercise price of $50

for $10
Value of
stock at
expiry 22-28
Covered Call Strategy

Value at
expiry
Buy the stock at $40
$10
Covered Call strategy
$0
Value of stock at expiry

$40 $50
-$30
-$40
Sell a call with exercise price

of $50 for $10
22-29
Option payoffs ($)
Long Straddle
Buy a call with exercise
price of $50 for $10
40
30
30
20
40
60
Stock price ($)

70
Buy a put with exercise

price of $50 for $10
$50
A Long Straddle only makes money if the stock price moves
$20 away from $50.
22-30
Option payoffs ($)
Short Straddle
This Short Straddle only loses money if the stock
price moves $20 away from $50.
20
Sell a put with exercise price of

$50 for $10
30
30
40
40
$50
60
70
Stock price ($)
Sell a call with an

exercise price of $50 for $10
22-31
Put-Call Parity: P0 + S0 = C0 + E/(1+ r)T
Option payoffs ($)
Portfolio value today = C0 +
E
(1+ r)T
Portfolio payoff
Call
bond
25
25
Stock price ($)
Consider the payoffs from holding a portfolio

consisting of a call with a strike price of $25 and a
bond with a future value of $25.
22-32
Put-Call Parity
Portfolio payoff
Option payoffs ($)
Portfolio value today = P0 + S0
25
Stock price ($)

25
Consider the payoffs from holding a portfolio consisting

22-33
of a share of stock and a put with a $25 strike.
Portfolio value today

E
= C0 +
(1+ r)T
25
Option payoffs ($)
Option payoffs ($)
Put-Call Parity
Portfolio value today
= P0 + S0
25
25
Stock price ($)
25
Stock price ($)
Since these portfolios have identical payoffs, they must have

the same value today: hence
Put-Call Parity: C0 + E/(1+r)T = P0 + S0
22-34
22.7 Valuing Options
The last section

concerned itself
with the value of
an option at
expiry.
This section
considers the
value of an option
prior to the
expiration date.
A much more
interesting
question.
22-35
American Call
ST
Option payoffs ($)
Profit
25
Call
Market Value
Time value
Intrinsic value
ST
E
Out-of-the-money
loss
In-the-money
C0 must fall within max (S0 E, 0) < C0 < S0.
22-36
Option Value Determinants

1.
2.
3.
4.
5.
Stock price
Exercise price
Interest rate
Volatility in the stock price
Expiration date
Call
+
+
+
+
Put
+
+
The value of a call option C0 must fall within
max (S0 E, 0) < C0 < S0.

The precise position will depend on these factors.
22-37
22.8 An Option Pricing Formula
We will start with

a binomial option
pricing formula to
build our
intuition.
Then we will
graduate to the
normal
approximation to
the 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 S1is 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(1.15)
$25
$21.25 = $25(1 .15)
22-39

1.
2.
A call option on this stock with exercise price of $25 will

have the following payoffs.
We can replicate the payoffs of the call option with a levered
position in the stock.
S0
S1
C1
$28.75
$3.75
$21.25
$0
$25
22-40

Borrow the present value of $21.25 today and buy 1 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 value today of the levered equity
portfolio is todays value of one share
less the present value of a $21.25 debt:
S0
$21.25
$25
(1 R f )
$28.75 $21.25 = $7.50
$3.75
$25
$21.25 $21.25 =
$0
$0
22-42

We can value the call option today as
half of the value of the levered equity
portfolio:
S0
1
$21.25
C0 $25
2
(1 R f )
$28.75 $21.25 = $7.50
$3.75
$25
$21.25 $21.25 =
$0
$0
22-43

If the interest rate is 5%, the call is worth:
1
$21.25 1
$25 20.24 $2.38
C0 $25
2
(1.05) 2
C0
$2.38
S0
$28.75 $21.25 = $7.50
$3.75
$25
$21.25 $21.25 =
$0
$0
22-44

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.
22-45
Delta
This practice of the construction of a riskless

hedge is called delta hedging.
The delta of a call option is positive.
Recall from the example:
$3.75 0
$3.75 1
Swing of call
Swing of stock
$28.75 $21.25 $7.5 2
The delta of a put option is negative.
22-46
Delta
Determining the Amount of Borrowing:

1
$21.25 1
$25 $20.24 $2.38
C0 $25
2
(1.05) 2
Value of a call = Stock price Delta

Amount borrowed
$2.38 = $25 Amount borrowed
Amount borrowed = $10.12
22-47
The Risk-Neutral Approach

S(U), V(U)
q
S(0), V(0)
1- q
S(D), V(D)
We could value the option, 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 )
22-48

S(U), V(U)
q
q is the risk-neutral
probability of an
up move.
S(0), V(0)
1- q
S(0) is the value of the underlying asset today.
S(D), V(D)
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 option in the next period
following an up move and a down move, respectively.
22-49

S(U), V(U)
q
V ( 0)
S(0), V(0)
q V (U ) (1 q ) V ( D )
(1 R f )
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 )
A minor bit of algebra yields: q
(1 R f ) S (0) S ( D )
S (U ) S ( D)
22-50
Example of Risk-Neutral Valuation

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)
$25,C(0)
$28.75,C(U)
$21.25 $25 (1 .15)
1- q
$21.25,C(D)
22-51

The next step would be to compute the risk neutral probabilities
q
(1 R f ) S (0) S ( D)
S (U ) S ( D )
(1.05) $25 $21.25

$5
q
2 3
$28.75 $21.25
$7.50
2/3
$28.75,C(U)
$25,C(0)
1/3
$21.25,C(D)
22-52

After that, find the value of the call in the up state and
down state.
C (U ) $28.75 $25
2/3
$25,C(0)
$28.75, $3.75
C ( D) max[$25 $28.75,0]
1/3
$21.25, $0
22-53

Finally, find the value of the call at time 0:
C ( 0)
q C (U ) (1 q ) C ( D)
(1 R f )
C ( 0)
2 3 $3.75 (1 3) $0
(1.05)
$2.50
C ( 0)
$2.38
(1.05)
2/3
$28.75,$3.75
$25,C(0)
$25,$2.38
1/3
$21.25, $0
22-54
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
$25 20.24 $2.38
C0 $25
2
(1.05) 2
22-55
The Black-Scholes Model

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
standardized, normally
2
d1
distributed, random
t
d 2 d1 t
variable will be less than

or equal to d.
The Black-Scholes Model allows us to value options in the

real world just as we have done in the 2-state world.
22-56

Find the value of a six-month call option on Hardcraft, Inc. with an
exercise price of $150.
The current value of a share of Hardcraft is $160.
The interest rate available in the U.S. is R = 5%.
The option maturity is 6 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 $10our
answer must be at least that amount.
22-57

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
0.52815
0.30 .5
Then,
d 2 d1 t 0.52815 0.30 .5 0.31602
22-58

C0 S N(d1 ) Ee Rt N(d 2 )
d1 0.52815
d 2 0.31602
N(d1) = N(0.52815) = 0.7013

N(d2) = N(0.31602) = 0.62401
C0 $160 0.7013 150e .05.5 0.62401

C0 $20.92
22-59
22.9 Stocks and Bonds as Options
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
Stocks and Bonds as Options
Levered equity is a put 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 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
Stocks and Bonds as Options
It all comes down to put-call parity.

E
C0 = S0 + P0
(1+ R)t
Value of a
call on the
firm
Value of a
Value of
= the firm + put on the
firm
Stockholders
position in terms
of call options
Stockholders
position in terms
of put options
Value of a
risk-free
bond
22-62
Mergers and Diversification
Diversification is a frequently mentioned reason for mergers.

Diversification reduces risk and, therefore, volatility.
Decreasing volatility decreases the value of an option.
Assume diversification is the only benefit to a merger:
Since equity can be viewed as a call option, should the merger

increase or decrease the value of the equity?
Since risky debt can be viewed as risk-free debt minus a put option,
what happens to the value of the risky debt?
Overall, what has happened with the merger and is it a good decision
in view of the goal of stockholder wealth maximization?
22-63
Example
Consider the following two merger candidates.

The merger is for diversification purposes only with no synergies involved.
Risk-free rate is 4%.
Market value of assets

Face value of zero
coupon debt
Debt maturity
Asset return standard
deviation
Company A
$40 million
$18 million
Company B
$15 million
$7 million
4 years
40%
4 years
50%
22-64
Example
Use the Black and Scholes OPM (or an options

calculator) to compute the value of the equity.
Value of the debt = value of assets value of equity
Company A Company B
Market Value of Equity
25.72
9.88
Market Value of Debt
14.28
5.12
22-65
Example
The asset return standard deviation for the combined firm is 30%
Market value assets (combined) = 40 + 15 = 55
Face value debt (combined) = 18 + 7 = 25
Combined Firm
Market value of equity
34.18
Market value of debt
20.82
Total MV of equity of separate firms = 25.72 + 9.88 = 35.60

Wealth transfer from stockholders to bondholders = 35.60 34.18 = 1.42
(exact increase in MV of debt)
22-66
M&A Conclusions
Mergers for diversification only transfer wealth
from the stockholders to the bondholders.
The standard deviation of returns on the assets
is reduced, thereby reducing the option value of
the equity.
If managements goal is to maximize
stockholder wealth, then mergers for reasons of
diversification should not occur.
22-67
Options and Capital Budgeting
Stockholders may prefer low NPV projects to high

NPV projects if the firm is highly leveraged and the
low NPV project increases volatility.
Consider a company with the following characteristics:
MV assets = 40 million
Face Value debt = 25 million
Debt maturity = 5 years
Asset return standard deviation = 40%
Risk-free rate = 4%
22-68
Example: Low NPV
Current market value of equity = $22.706 million

Current market value of debt = $17.294 million
NPV
MV of assets
Asset return standard
deviation
MV of equity
MV of debt
Project I
$3
$43
30%
Project II
$1
$41
50%
$23.831
$19.169
$25.381
$15.169
22-69
Example: Low NPV

Which project should management take?
Even though project B has a lower NPV, it is
better for stockholders.
The firm has a relatively high amount of leverage:
With project A, the bondholders share in the NPV

because it reduces the risk of bankruptcy.
With project B, the stockholders actually appropriate
additional wealth from the bondholders for a larger
gain in value.
22-70
Example: Negative NPV

We have seen that stockholders might prefer a low
NPV to a high one, but would they ever prefer a
negative NPV?
Under certain circumstances, they might.
If the firm is highly leveraged, stockholders have
nothing to lose if a project fails, and everything to
gain if it succeeds.
Consequently, they may prefer a very risky project
with a negative NPV but high potential rewards.
22-71

Consider the previous firm.
They have one additional project they are
considering with the following characteristics
Project NPV = -$2 million

MV of assets = $38 million
Asset return standard deviation = 65%
Estimate the value of the debt and equity

MV equity = $25.453 million
MV debt = $12.547 million
22-72

In this case, stockholders would actually prefer
the negative NPV project to either of the
positive NPV projects.
The stockholders benefit from the increased
volatility associated with the project even if
the expected NPV is negative.
This happens because of the large levels of
leverage.
22-73
Options and Capital Budgeting

As a general rule, managers should not accept
low or negative NPV projects and pass up high
NPV projects.
Under certain circumstances, however, this may
benefit stockholders:
The firm is highly leveraged

The low or negative NPV project causes a substantial
increase in the standard deviation of asset returns
22-74
22.11 Investment in Real Projects and Options
Classic NPV calculations generally ignore

the flexibility that real-world firms
typically have.
Option to expand
Option to abandon
22-75
Quick Quiz
What is the difference between call and put options?

What are the major determinants of option prices?
What is put-call parity? What would happen if it does
not hold?
What is the Black-Scholes option pricing model?
How can equity be viewed as a call option?
Should a firm do a merger for diversification
purposes only? Why or why not?
Should management ever accept a negative NPV
project? If yes, under what circumstances?
22-76

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Chap 022

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Chapter

Options and Corporate Finance

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Understand option terminology

Strike Price or Exercise Price

The act of buying or selling the underlying asset

Expiry (Expiration Date)

The maturity date of the option

European versus American options

Exercising the option would result in a positive payoff.

European options can be exercised only at expiry.

Exercising the option would result in a zero payoff (i.e., exercise

Exercising the option would result in a negative payoff.

22.2 Call Options

Call options gives the holder the right,

Call Option Pricing at Expiry

At expiry, an American call option is worth the same

If the call is in-the-money, it is worth ST E.

If the call is out-of-the-money, it is worthless:

Call Option Payoffs

Option payoffs ($)

Exercise price = $50

Call Option Profits

Exercise price = $50; option premium = $10

22.3 Put Options

Put options gives the holder the right,

Put Option Pricing at Expiry

At expiry, an American put option is worth

Put Option Payoffs

Exercise price = $50

Put Option Profits

Stock price ($)

Exercise price = $50; option premium = $10

The difference between the option premium and the intrinsic

22.4 Selling Options

The seller (or writer) of an option has an

Call Option Payoffs

Exercise price = $50

Put Option Payoffs

Exercise price = $50

Option profits ($)

Option Diagrams Revisited

Stock price ($)

Exercise price = $50;

22.5 Option Quotes

--Call---Put-Vol. Last Vol. Last

--Call---Put-Vol. Last Vol. Last

a recent price for the stock is $138.25;

--Call---Put-Vol. Last Vol. Last

--Call---Put-Vol. Last Vol. Last

Since the option is on 100 shares of stock, buying this option

--Call---Put-Vol. Last Vol. Last

--Call---Put-Vol. Last Vol. Last

Since the option is on 100 shares of stock, buying this

22.6 Combinations of Options

Puts and calls can serve as the

Protective Put Strategy (Payoffs)

Protective Put payoffs

Buy a put with an exercise

Protective Put Strategy (Profits)

Buy the stock at $40

Buy a put with exercise price of $50

Covered Call Strategy