HB 311 1st Edition Lecture 13Valuation of Stock Pt. 3Call Options • The more volatile the stock’s price the more attractive the option– The stock’s price is more likely to exceed the strike price before the option expires• The longer the time until expiration the more attractive the option– The stock’s price is more likely to exceed the strike price before the option expiresThe Call Option Writer • The option writer is the person who creates the contract– Agrees to sell the stock at the strike price if the option is exercised• The original writer must stand ready to deliver on the contract regardless of how many times the option is sold • Call writer hopes stock price will remain the sameIntrinsic Value • A call option’s intrinsic value is the difference between the underlying stock’s current price and the option’s strike price• If the option is out-of-the-money then the intrinsic value is zero• Option will always sell for intrinsic value or above– Difference between option’s intrinsic value and price is known as time valueOptions and Leverage • Financial leverage These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.– Technique that amplifies return on investment • Improves positive returns and worsens negative returns• Options offer leveraging potential due to the lower price at which you can buy an option compared to the price of the underlying stock– The higher the price of the option the less the leverage potentialOptions that Expire • Option investing is risky because options expire after a limited time• If the option was purchased out-of-the-money and the stock price never exceeds the strike price prior to the expiration date the option will expire worthless– Resulting in a 100% loss• As the expiration date approaches an option’s time value approaches zeroTrading in Options • Options can be bought and sold at any time prior to expiration– Chicago Board Options Exchange (CBOE) is the largest, oldest and best known options exchange• Price volatility in the options market– As the price of the underlying stock changes the price of the option changes but by a greater relative movement due to the lower price of the option compared tothe stock• Options are rarely exercised before expiration– If the call option owner believes a stock is unlikely to increase further he is likely to sell the option rather than exercise it as he would lose any time premium if he were to exercise the optionWriting Options • People write options for the premium income, hoping that the option will never be exercised• Option writers lose whatever option buyers win– Take the opposite side of a bet• Covered option—the writer owns the underlying stock• Naked option—the writer does not own the underlying stock and must purchase it at the current price should the option be exercisedPut Options • An option to sell an underlying asset at a specified price by a specified date• Would buy a put if you thought the price of the underlying asset were going to fall• Intrinsic value is how much the option is in-the-money• Option is in-the-money if the strike price is lower than the current stock priceOption Pricing Models • Option pricing model is more difficult than pricing models for stocks and bonds• Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model– Determines option’s price based on• Price of underlying stock• Strike price of option• Time remaining until expiration of option• Volatility of underlying stock’s market price• Risk-free interest rateWarrants • Options trade between investors, not between the companies that issue the underlying stocks• Warrants are issued by the underlying companies– When the warrant is exercised the company issues new stock and receives the exercise price• Thus, warrants are primary market instruments while options are secondary market instruments• Similar to call options but have a longer expiration period (several years vs. months)• Usually issued as a “sweetener” (for bonds, for instance)• Warrants can generally be detached from another issue and sold separatelyEmployee Stock Options • More like warrants than traded options– Don’t expire for several years– Strike prices are set far out of the money– Employees who receive options generally receive a lower salary than they would otherwise• If a company is expected to have a good future employees may want to receive options• Companies like paying with options because they can pay the employees a lower salary– Argue that options allow up-and-coming companies to attract talented employees that they couldn’t otherwise affordThe Executive Stock Option Problem • Senior executives are usually the people who receive the most stock options• Tactic has been criticized recently– May cause executive to try to increase stock price in unethical ways• Manipulating financial results driving the stock price higher– Market should eventually realize the problem and drive the stock down but executives have already exercised their stock options and sold the stock at the inflated price• This can negatively impact a firm’s pension plan if it is heavily invested in its firm’s own stock• In the early 2000s investors realized that auditors couldn’t (or wouldn’t) always report financial manipulations– Enron, WorldCom, Tyco– Resulted in a loss of investor confidence in corporate management• One result of the overhaul of financial reporting is the requirement that companies recognize employee stock options as expenses at the time they are issued– Problem is that no one knows how high the stock will rise in value at the time theoptions are