PowerPoint PresentationKey Concepts and SkillsChapter Outline17.1 OptionsOptions17.2 Call OptionsCall Option Pricing at ExpiryCall Option PayoffsCall Option Profits17.3 Put OptionsPut Option Pricing at ExpiryPut Option PayoffsPut Option ProfitsOption Value17.4 Selling OptionsSlide 16Slide 17Option Diagrams Revisited17.5 Option QuotesOption QuotesSlide 21Slide 22Slide 23Slide 24Slide 2517.6 Combinations of OptionsProtective Put Strategy (Payoffs)Protective Put Strategy (Profits)Covered Call StrategyLong StraddleShort StraddlePut-Call Parity: P0 + S0 = C0 + E/(1+ R)TPut-Call ParitySlide 3417.7 Valuing OptionsAmerican CallOption Value Determinants17.8 An Option Pricing FormulaBinomial Option Pricing ModelSlide 40Slide 41Slide 42Slide 43Slide 44Slide 45DeltaSlide 47The Risk-Neutral ApproachSlide 49Slide 50Example of Risk-Neutral ValuationSlide 52Slide 53Slide 54Risk-Neutral Valuation and the Replicating PortfolioThe Black-Scholes ModelSlide 57Slide 58Slide 5917.9 Stocks and Bonds as OptionsStocks and Bonds as OptionsSlide 62Quick Quiz17-1OPTIONS AND CORPORATE FINANCEChapter 17Copyright © 2014 McGraw-Hill Education. 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No reproduction or distribution without the prior written consent of McGraw-Hill Education.17-2KEY CONCEPTS AND SKILLS•Define option terminology•Determine option payoffs and profits•Describe the major determinants of option prices•Grasp and apply put-call parity•Determine option prices using the binomial and Black-Scholes models17-3CHAPTER OUTLINE17.1 Options17.2 Call Options17.3 Put Options17.4 Selling Options17.5 Option Quotes17.6 Combinations of Options17.7 Valuing Options17.8 An Option Pricing Formula17.9 Stocks and Bonds as Options17-417.1 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•The act of buying or selling the underlying asset •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 (Expiration Date)•The maturity date of the option17-5OPTIONS•European versus American options•European options can be exercised only at expiry.•American options can be exercised at any time up to expiry.•In-the-Money•Exercising the option would result in a positive payoff. •At-the-Money•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.17-617.2 CALL OPTIONS•Call options give 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.17-7CALL 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]WhereST is the value of the stock at expiry (time T)E is the exercise price.C is the value of the call option at expiry17-8CALL OPTION PAYOFFS–2012020 40 6080100–40204060Stock price ($)Option payoffs ($)Buy a callExercise price = $505017-9CALL OPTION PROFITSExercise price = $50; option premium = $10Buy a call–2012020 40 6080100–40204060Stock price ($)Option payoffs ($)50–10 1017-1017.3 PUT OPTIONS•Put options give the holder the right, but not the obligation, to sell a given quantity of an asset on or before some time in the future, at prices agreed upon today. •When exercising a put, you “put” the asset to someone.17-11PUT OPTION PRICING AT EXPIRY•At expiry, an American put option is worth the same as a European option with the same characteristics.•If the put is in-the-money, it is worth E – ST.•If the put is out-of-the-money, it is worthless.P = Max[E – ST, 0]17-12PUT OPTION PAYOFFS–200 20 40 6080100–402004060Stock price ($)Option payoffs ($)Buy a putExercise price = $50505017-13PUT OPTION PROFITS–2020 40 6080100–40204060Stock price ($)Option payoffs ($)Buy a putExercise price = $50; option premium = $10–10 105017-14OPTION VALUE•Intrinsic Value•Call: Max[ST – E, 0]•Put: Max[E – ST , 0]•Speculative Value•The difference between the option premium and the intrinsic value of the option.Option Premium=Intrinsic ValueSpeculative Value+17-1517.4 SELLING OPTIONS•The seller (or writer) of an option has an obligation.•The seller receives the option premium in exchange.17-16CALL OPTION PAYOFFS–2012020 40 6080100–40204060Stock price ($)Option payoffs ($)Sell a callExercise price = $505017-17PUT OPTION PAYOFFS–200 20 40 6080100–4020040–50 Stock price ($)Option payoffs ($)Sell a putExercise price = $505017-18OPTION DIAGRAMS REVISITEDExercise price = $50; option premium = $10Sell a callBuy a call506040100–4040Stock price ($)Option payoffs ($)Buy a putSell a put–10 10Buy a callSell a putBuy a putSell a call17-1917.5 OPTION QUOTESOption /Strike Exp. Vol. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 243113/16138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½--Put----Call--17-20OPTION QUOTESOption /Strike Exp. Vol. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 243113/16138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½--Put----Call--This option has a strike price of $135; a recent price for the stock is $138.25; July is the expiration month.17-21OPTION QUOTESOption /Strike Exp. Vol. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 243113/16138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½--Put----Call--This makes a call option with this exercise price in-the-money by $3.25 = $138¼ – $135. Puts with this exercise price are out-of-the-money.17-22OPTION QUOTESOption/Strike Exp. Vo l. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 243113/16138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½--Pu t----Call--On this day, 2,365 call options with this exercise price were traded.17-23OPTION QUOTESOption/Strike Exp. Vol. Last Vol. LastIBM 130