Chapter 20 Options and Corporate Finance

Learning Objectives
1. Define a call option and a put option, and describe the payoff function for each of these options. 2. List and describe the factors that affect the value of an option . !a"e so"e of the real options that occur in business and e#plain $hy traditional !%& analysis does not accurately incorporate their values. '. Describe ho$ the agency costs of debt and e(uity are related to options. ). *#plain ho$ options can be used to "anage a fir"+s e#posure to ris,.

-.

Chapter Outline
20.1 Financial Options A financial option is a derivative security in that its value is derived from the value of another asset. The owner of a financial option has the right, but not the obligation, to buy or sell an asset on or before a specified date for a specified price. The asset that the owner has a right to buy or sell is known as the underlying asset.

The last date on which an option can be exercised is called the e#ercise date or e#piration date, and the price at which the option holder can buy or sell the asset is called the e#ercise price or stri,e price.

A.

Call Options A call option gives the owner the right to buy, or call, the underlying asset. Once the asset price goes above the exercise price, the value of the call option at exercise increases dollar for dollar with the price of the underlying asset. The buyer pays the seller a fee to purchase the option. This fee, which is known as the call pre"iu", makes the total return to the seller positive when the price of the underlying asset is near or below the exercise price.

B.

Put Options The owner of a put option has the right to sell the underlying asset at a prespecified price. The payoff function for the owner of a put option is similar to that for a call option, but it is the reverse in the sense that the owner of a put option profits if the price of the underlying asset is below the exercise price. The owner of a put option will not want to exercise that option if the price of the underlying asset is above the exercise price.

hen the value of the underlying asset is below the exercise price, however, the owner of the put option will find it profitable to exercise the option.

The payoff for the seller of the put option is negative when the price of the underlying asset is below the exercise price.

The seller of a put option hopes to profit from the fee, or put pre"iu", that he or she receives from the buyer of the put option.

C.

American, European, and Bermudan Options Options that can only be exercised on the expiration date are known as European options. American options can be exercised at any point in time on or before the expiration date. Bermudan options can be exercised only on specific dates during the life of the option.

D.

More on the Shapes of Option Payoff Functions The payoff functions for options are not straight lines for all possible values of the underlying asset. !ach payoff function has a kink at the exercise price, which exists because the owner of the option has a right, but not the obligation, to buy or sell the underlying asset. "f it is not in the owner#s interest to exercise the option, he or she can simply let it expire.

20.2

Option &aluation "t is more complicated to determine the value of an option at a point in time before the expiration date because we don#t know exactly how the value of the underlying asset will change over time, and therefore we don#t know if it will make sense to exercise the option. A. Limits on Option alues e know that the value of a call option can never be less than $ero, since the owner of the option can always decide not to exercise it if doing so is not beneficial. The value of a call option can never be greater than the value of the underlying asset because it would not make sense to pay more for the right to buy an asset than you would pay for the asset itself. The value of a call option prior to expiration will never be less than the value of that option at expiration because there is always a possibility that the value of the underlying asset will be greater than it is today at some time before the option expires. hen we consider the value of a call option at some time prior to expiration, we must compare the current value of the underlying asset with the present value of the exercise price, discounted at the risk-free rate. The present value of the exercise price is the amount that an investor would have to invest in risk%free securities at any point prior to the expiration date to ensure that he or she would have enough money to exercise the option when it expired.

B.

aria!les "hat Affect Option alues The higher the current value of the underlying asset, the more likely it is that the value of the asset will be above the exercise price when the call option expires. The higher the current value of the asset, the greater the likely difference between the value of the asset and the exercise price when the option expires. This means that, holding the exercise price constant, investors will pay more for a call option if the underlying asset value is higher, because the expected value of the option at expiration is higher. The opposite relation applies to the exercise price in that the lower the exercise price, the more likely that the value of the underlying asset will be higher than the exercise price when the option expires. The greater the volatility of the underlying asset value, the higher the value of a call option on the asset prior to valuation. The intuition here is that the value of an option will increase more when the value of the underlying asset goes up than it will decrease when the value of the underlying asset goes down. This means that a greater potential change in the underlying price will be more beneficial to the value of the option.

The greater the time to maturity, the more the value of the underlying asset is likely to change by the time the option expires& this increases the value of an option. The time until the expiration affects the value of a call option through its effect on the volatility of the value of the underlying asset.

The value of a call option increases with the risk%free rate. !xercising a call option involves paying cash in the future for the underlying asset. The higher the interest rate, the lower the present value of the amount that the owner of a call option will have to pay to exercise it, which translates into value for the owner of the option.

C.

"he Binomial Pricin# Model This simple model assumes that the underlying asset will have one of only two possible values when the option expires. The value of the underlying asset will either increase to some value above the exercise price or decrease to some value below the exercise price. To solve for the value of the call option using this model, we must assume that investors have no arbitrage opportunities with regard to this option.

.rbitrage is the act of buying and selling assets in a way that yields a return above that suggested by the 'ecurity (arket )ine *'()+.

To value the call option in our simple model, we will first create a portfolio that consists of the asset underlying the call option and a risk% free loan. The relative investments in these two assets will be selected so that the combination of the asset and the loan has the same cash flows as the call option when it expires, regardless of whether the value of the underlying asset goes up or down. This is called a replicating portfolio, since it replicates the cash flows of the option. The replicating portfolio will consist of, x shares of the underlying stock, and a risk%free loan with a face value of y.

The value of the call option can be calculated. 'olve for the values of x and y. (ultiply the current cost of the underlying stock by x. 'ubtract y from the above amount to yield the value of the call option.

D.

Put$Call Parity Although there are other methods, the value of a put option can be calculated by the relationship of a put to a call option with the same maturity and exercise price.

This relation is called put/call parity. The formula for put%call parity is,

- . / 0 1e2rt 2 3, where P is the value of the put option, C is the value of the call option, X is the exercise price, is the current value of the underlying asset, and e is the exponential function.

20.

0eal Options 0eal options are options on real assets. 4-3 analysis does not ade5uately reflect the value of real options, and while it might not always be possible to directly estimate the value of the real options associated with a pro6ect, it is important to recogni$e that they exist when we perform a pro6ect analysis. A. Options to Defer %n&estment An example is as stated in the text concerning the 7ussian government and an oil field development pro6ect. "n the example, the 7ussian government waited to see what happened to the price of oil before deciding to exercise its option to ac5uire an ownership interest in the 'akhalin "" pro6ect. The underlying asset in this option is the stream of cash flows that the developed oil field would produce, while the exercise price is

the amount of money that the company would have to spend to develop it *drill the well and build any necessary infrastructure+. The value of an option to defer investment is not reflected in an 4-3 analysis, for 4-3 analysis does not allow for the possibility of deferring an investment decision. B. Options to Ma'e Follo($On %n&estments 'ome pro6ects open the door to future business opportunities that would not otherwise be available. This type of real option is an option to make follow-on investments. Options to make follow%on investments are inherently difficult to value because, at the time we are evaluating the original pro6ect, it may not be obvious what the follow%on pro6ects will be. !ven if we know what the pro6ects will be, we are unlikely to have enough information to estimate what they are worth. -ro6ects that lead to investment opportunities that are consistent with a company#s overall strategy are more valuable than otherwise similar pro6ects that do not. C. Options to Chan#e Operations Options to change operations are related to the flexibility that managers have once an investment decision has been made. These include the option to change operations and to abandon a pro6ect. These options affect the 4-3 of a pro6ect and must be taken into account at the time the investment decision is made.

The changes that managers might make can involve something as simple as reducing output if prices decline or increasing output if prices increase.

D. Options to A!andon Pro)ects An option to abandon a pro!ect is the ability to choose to terminate a pro6ect by shutting it down. (anagement will save money that would otherwise be lost if the pro6ect kept going. The amount saved represents the gain from exercising this option. E. Concludin# Comments on *P Analysis and +eal Options "n order to use 4-3 analysis to value such an option, we would not only have to estimate all the cash flows associated with the expansion but would also have to estimate the probability that we would actually undertake the expansion and determine the appropriate rate at which to discount the value of the expansion back to the present.

20.'

.gency Costs Agency conflicts between stockholders and debt holders and between stockholders and managers arise because the interests of stockholders, lenders *creditors+, and managers are not perfectly aligned. One reason is that the claims that they have against the cash flows produced by the firm have payoff functions that look like different types of options. A. A#ency Costs of De!t

The payoff functions for stockholders and lenders *creditors+ differ, as do the payoff functions for different options.

The payoff function for the stockholders looks exactly like that for the owner of a call option, where the exercise price is the amount owed on the loan and the underlying asset is the firm itself. "f the value of the firm exceeds the exercise price, the stockholders will choose to exercise their option& if it does not exceed the exercise price, they will let their option expire unexercised.

One way to think about the payoff function for the lenders is that when they lend money to the firm, they are essentially selling a put option to the stockholders. This option gives the stockholders the right to put the assets to the lenders for an exercise price that e5uals the amount they owe. hen the value of the firm is less than the exercise price, the stockholders will exercise their option by defaulting.

1he Dividend %ayout %roble"2 The incentives that stockholders of a leveraged firm have to pay themselves dividends arise because of their option to default. "f a company faces some realistic risk of going bankrupt, the stockholders might decide that they are better off taking money out of the firm by paying themselves dividends. This situation can arise because the stockholders know that the bankruptcy laws limit their possible losses.

1he .sset 3ubstitution %roble"2

hen bankruptcy is possible,

stockholders have an incentive to invest in very risky pro6ects, some of which might even have negative 4-3s. 'tockholders have this incentive because they receive all of the benefits if things turn out well but do not bear all of the costs if things turn out poorly. 1he 4nderinvest"ent %roble"2 'tockholders have incentives to turn down positive%4-3 pro6ects when all of the benefits are likely to go to the lenders. The problem arises from the differences in the payoff functions. B. A#ency Costs of E,uity (anagers are hired to manage the firm on behalf of the stockholders, but managers do not always act in the stockholders# best interest. The payoff function for a manager can be 5uite different from that for stockholders. "n fact, it can look a lot like that for a lender. "f a company gets into financial difficulty and a manager is viewed as responsible, that manager could lose his or her 6ob and find it difficult to obtain a similar 6ob at another company. o The most obvious way for a company to get into financial difficulty is to default on its debt. o Thus, as long as a company is able to avoid defaulting on its debt, a manager has a reasonable chance of retaining his or her 6ob.

The fact that the payoff function for a manager resembles that for a lender means that managers, like lenders, have incentives to invest in less risky assets and to distribute less value through dividends and stock repurchases than the stockholders would like.

20.)

Options and 0is, 5anage"ent 7isk management typically involves hedging or reducing the financial risks faced by a firm. Options, along with other derivative instruments, such as forwards, futures, and swaps, are commonly used to reduce risks associated with commodity prices, interest rates, foreign exchange rates, and e5uity prices. One interesting benefit of using options in this way is that they provide downside protection but do not limit the upside. This is 6ust like buying insurance. o (any insurance contracts are little more than speciali$ed put options. Options and other derivative instruments can be used to manage commodity price risks, large swings in interest rates, risks associated with foreign exchange rates, as well as to manage risks associated with e5uity prices as occurs within defined benefit pension plans.

--.

3uggested and .lternative .pproaches to the 5aterial

/hapter 89 considers the description, valuation, and use of options. The discussion begins with financial options and how they are valued in a simple model. The chapter then turns to options on real assets, known as real options. 7eal options often arise in corporate investment decisions, such as the right to delay investing in a pro6ect, expanding a pro6ect, abandoning a pro6ect, or making a change in the technology employed in a pro6ect. This framework provides a valuation tool that is not properly reflected in an 4-3 analysis. The chapter then revisits the agency costs of debt discussed earlier in /hapter :;. The option%like payoffs that are embedded in the payoff to e5uity investors contribute to the problems of asset substitution, underinvestment, dividend payout, and claim dilution. The discussion then follows with how option%like payoffs contribute to conflicts between stockholders and the managers. The chapter concludes with a discussion of the ways in which managers use financial options to alter their companies# exposures to various types of risks. This material is generally considered advanced for a first course in finance, but the sub6ect matter is presented through a simple real%world discussion and the concepts are easy for students to grasp. "t is a chapter that students generally find interesting, given the fre5uent appearance of derivatives in the popular press.

---. 3u""ary of Learning Objectives

:. Define a call option and a put option, and describe the payoff function for each of these options.

An option is the right, but not the obligation, to buy or sell an asset for a given price on or before a given date. The price is called the exercise or strike price, and the date is called the exercise date or expiration date of the option. The right to buy the asset is known as a call option. The payoff from a call option e5uals <9 if the value of the underlying asset is less than the exercise price at expiration. "f the value of the underlying asset is higher than the exercise price at expiration, then the payoff from the call option is e5ual to the value of the asset value minus the exercise price. The right to sell the asset is called a put option. The payoff from a put option is <9 if the value of the underlying asset is greater than the exercise price at expiration. "f the value is lower than the exercise price, then the payoff from a put option e5uals the exercise price minus the value of the underlying asset.

8.

List and describe the factors that affect the value of an option.

The value of an option is affected by five factors, the current price of the underlying asset, the volatility of the value of the underlying asset, the time left until the expiration of the option, the exercise price of the option, and the risk%free rate.

=.

!a"e so"e of the real options that occur in business, and e#plain $hy traditional !%& analysis does not accurately incorporate their value.

7eal options that are associated with investments include options to defer investment, make follow%on investments, change operations, and abandon pro6ects. Traditional 4-3 analysis is designed to make a decision to accept or re6ect a pro6ect at a particular point in time. "t is not intended to incorporate potential value associated with deferring the investment decision. "ncorporating the value of the other options into an 4-3 framework is technically possible but would be very difficult to do because the rate used to discount the cash flows would change over time with their riskiness. "n addition, the information necessary to value real options using the 4-3 approach is not always available.

'.

Describe ho$ the agency costs of debt and e(uity are related to options.

There are two principal classes of agency conflicts. The first is between stockholders and lenders. hen there is a risk of bankruptcy, stockholders may have incentives to increase

the volatility of the firm#s assets, turn down positive%4-3 pro6ects, or pay out assets in the form of dividends. 'tockholders have these incentives because their payoff functions look like those for the owners of a call option. The other principal class of agency conflict is between managers and owners. (anagers tend to prefer less risk than stockholders and prefer to distribute fewer assets in the form of dividends because their payoff functions are more like those of lenders than those of stockholders. These preferences are magnified by the fact that managers are risk% averse individuals whose portfolios are not well diversified.

).

*#plain ho$ options can be used to "anage a fir"+s e#posure to ris,.

A company can ad6ust its exposure to risks associated with commodity prices, interest rates, foreign exchange rates, and e5uity prices by buying or selling options. >or example, a company that is concerned about the prices it will receive for products that will be delivered in the future can purchase put options to partially or totally eliminate that risk.

-&. 3u""ary of 6ey *(uations

*(uation 20.1

Description -ut%call parity

For"ula - . / 0 1e%rt 2 3

&.

7efore 8ou 9o On :uestions and .ns$ers

3ection 20.1
:. hat is a call option, and what do the payoff functions for the owner and seller of a call option look like?

A call option gives the owner the right to buy or call the underlying asset at a prespecified price. The payoff for the owner of a call option is $ero when the value of the underlying asset is below the exercise price, and increases dollar for dollar with the price of the underlying asset once the asset price goes above the exercise price. The payoff for the seller of a call option is 9 when the value of the underlying asset is below the exercise price, and decreases dollar for dollar with the price of the underlying asset once the asset price goes above the exercise price.

8.

hat is a put option, and what do the payoff functions for the owner and seller of a put option look like?

A put option gives the owner the right to sell the underlying asset at a prespecified price. The payoff for the owner of a put option is 9 when the value of the underlying asset is above the exercise price, and increases dollar for dollar with decrease of the price of the underlying asset when the asset price drops below the exercise price. The payoff for the seller of a put option is 9 when the value of the underlying asset is above the exercise price, and decreases dollar for dollar with decrease of the price of the underlying asset once the asset price drops below the exercise price.

=.

hy does the payoff function for an option have a kink in it?

The payoff function for an option has a kink at the exercise price. This kink exists because the owner of the option has a right, not an obligation, to buy or sell the underlying asset. "f it is not in the owner#s interest to exercise the option, he or she can simply let it expire.

3ection 20.2
:. hat are the limits on the value of a call option prior to its expiration date?

The value of a call option can never be less than $ero since the owner of the option can always decide not to exercise it if doing so is not beneficial. A second limit on the value of a call option is that it can never be greater than the value of the underlying asset. "t would not make sense to pay more for the right to buy an asset than you would pay for the asset itself. The third limit is that the value of a call option prior to expiration will never be less than the value of that option at expiration. @ecause of the time value of money, the final limit is that the value of a call option prior to expiration will never be less than the difference between the current value of the underlying asset and the present value of the exercise price.

8.

hat variables affect the value of a call option?

The following five variables affect the value of a call option prior to expiration, *:+ /urrent value of the underlying asset *8+ !xercise price *=+ 3olatility of the value of the underlying asset *A+ Time until the expiration of the option *B+ 7isk%free rate of interest

=.

hy are the variables that affect the value of a put option the same as those that affect the value of a put option?

Civen the value of a call option, the value of a put option can be calculated using the put% call parity, - . / 0 1e%rt 2 3. e can see that the formula does not include any variables

other than the five factors in valuation of a call option.

3ection 20.

:.

hat is a real option?

7eal options are options on real assets. "n some cases, the value of real options can be incorporated into an investment analysis by valuing the option separately using valuation methods similar to those used to value financial options, and then adding this value to the value estimated by traditional 4-3 analysis.

8.

hat are four different types of real options commonly found in business?

*:+ Options to defer investment *8+ Options to make follow%on investments *=+ Options to change operations *A+ Options to abandon pro6ects

=.

"s it always possible to estimate the value of a real option?

hy or why not?

"n some instances, it is not possible to estimate the value of a real option because we do not have enough information or because the necessary analysis is too complex. Although it might not even be possible to directly estimate the value of the real options associated with a pro6ect, it is important to recogni$e that they exist when you perform a pro6ect analysis.

3ection 20.'
:. hat do the payoff functions for stockholders and lenders look like?

The payoff function for the stockholders looks exactly like that for the owner of a call option where the exercise price is the amount owed on the loan and the underlying asset is the firm itself. The payoff function for the lenders looks like that for the seller of a put option, where the exercise price is the amount of the loan and the underlying asset is the firm itself.

8.

hat does the payoff function for a typical manager look like?

hen a company defaults on its debt, the payoff function for the manager will look something like that for the lenderDit will slope downward as the value of the firm decreases. On the positive side, a manager#s payoff will increase with the value of the firm when this value is above the amount that the company owes to its lenders.

3ection 20.)
:. hat is hedging?

Eedging is a method of reducing financial risks faced by a firm. Options, along with other derivative instruments, such as forwards, futures, and swaps, are commonly used in hedging.

8.

hat types of risks can options be used to manage?

Options can be used to manage risks associated with commodity prices, interest rates, foreign exchange rates, and e5uity prices.

&-. 3elf/3tudy %roble"s

20.1

Of the two parties to an option contract, the buyer and the seller, who has a right and who has an obligation?

3olution2 The buyer *owner+ of the option has the right to exercise the option but is not re5uired to do so. The seller *or writer+ of the option is obligated to take the other side of the transaction if the option owner decides to exercise it.

20.2

The stock of Augusta )ight and -ower is currently selling at <:8 per share. Over the next year the company is undertaking a new electricity production pro6ect. "f the pro6ect is successful, the company#s stock is expected to rise to <8A per share. "f the pro6ect fails, the stock is expected to fall to <F per share. The risk%free rate is ; percent. /alculate the value today of a one%year call option on one share of Augusta )ight and -ower with an exercise price of <89.

3olution2 >irst, determine the payoffs for the stock, a risk%free loan, and the call option under the two possible outcomes. "n one year, the stock price is expected to be either <F or <8A. The loan will be worth <:.9; regardless of whether the pro6ect is successful. "f the pro6ect fails, the stock price will be less than the exercise price of the call option. The option will not be exercised and will be worth <9. "f the pro6ect is successful, the stock price will be

higher than the exercise price of the call option. The option will be exercised& its value would be the difference between the stock price and the exercise price, <A. Stoc' -./ Today <:8 +is'$Free Loan -y/ <: Call Option ?

!xpiration

<F

<8A

<:.9;

<:.9;

<9

<A

The stock and loan can be used to create a tracking portfolio, which has the same payoff as the call option, *<F G x+ 0 *:.9; G "+ . <9 <8A G x+ 0 *:.9; G "+ . <A 'olving the two e5uations yields, x . 9.8B, " . %:.FFH The value if the call option is the same as the current value of the portfolio, *<:8 G 9.8B+ 0 *<: G %:.FFH+ . <:.::

20.

AI/-A "nternational is a J.'.%based company that sells its products primarily in overseas markets. The company#s stock is currently trading at <B9 per share. Iepending on the outcome of J.'. trade negotiations with the countries to which AI/A- exports its products, the company#s stock price is expected to be either <;B or <=9 in six months. The risk%free rate is F percent per year. hat is the value of a put option on AI/A-

stock that has an exercise price of <A9 per share?

3olution2

>irst determine the payoffs for the stock, a risk%free bond, and the put option under the two possible outcomes. To determine payoff of the bond six months from now, we must calculate the six%month risk%free interest rate given the one%year risk%free rate listed in the problem statement. 'ix%month risk%free rate . *: 09.9F+:K8 2 : . :.9=L, or =.LM The payoffs are therefore, Stoc' -./ Today <B9 +is'$Free Loan -y/ <: Put Option ?

!xpiration

<=9

<;B

<:.9=L

<:.9=L

<:9

<9

4ow we can use the stock and bond to create a tracking portfolio, which will give the same payoff as the put option, *<=9 G x+ 0 *:.9=L G "+ . <:9 *<;B G x+ 0 *:.9=L G "+ . <9 'olving the two e5uations, we determine x . 29.8F;, " . :H.FH The value of the put option is the same as the current value of this portfolio, *<B9 G 29.8F;+ 0 *<: G :H.FH+ . <=.BF Alternatively, you could solve this problem by calculating the value of a call option with an exercise price of <A9 per share and then using the put%call parity relation. The value of the call option is <:B.9L, and the value of the associated put option calculated using the

put%call parity relation is <=.B8. The difference is due to rounding and the compounding assumption for the discount rate.

20.'

Nour company is considering opening a new factory in !urope to serve the growing demand for your product there. hat real options might you want to consider in your

capital budgeting analysis of the factory?

3olution2 At least two significant real options might be associated with the factory. >irst, the existence of a factory in !urope, and of the employees and management associated with it, may enable your company to introduce products to the !uropean markets. 'econd, if things go badly for your !uropean presence, you may be able to sell the factory and abandon the pro6ect.

20.) Nour firm, which uses oil as an input to its production processes, hedges its exposure to changes in the price of oil by buying call options on oil at today#s price. "f the price of oil goes down by the time the contract expires, what effect will that have on your company?

3olution2 The effect on your company of the decline in the price of oil will be to increase earnings. This is because the oil is an input to your production process, and a drop in prices will reduce your expenses. 'ince the price of oil went down, you would let the call option

expire without exercising it. Of course, the benefit your company receives from the drop in oil prices will be reduced by the amount that you paid to purchase the option. .

&--. Critical 1hin,ing :uestions

20.1

Options can be combined to create more complicated payoff structures. /onsider the combination of one put option and one call option with the same expiration date and the same strike price. Iraw the payoff diagram and describe what the purchaser of such a combination thinks will happen before expiration.

The payoff diagram will be in the shape of a 3 centered at the strike price, @uy -ut

and 3alue / al l

'tock -rice

This combination is called a straddle. "ts purchaser thinks that the value of the underlying asset will change significantly, but he is unsure in which direction it will move. "f he is correct, one of his options will expire worthless, but the other will be exercised *and have value+. "f he is wrong, the payoff from the option that ends up being exercised will not be enough to cover the expense of buying the options in the first place.

20.2

A writer of a call option may or may not actually own the underlying asset. "f he or she owns the asset, and therefore will have the asset available to deliver should the option be exercised, he or she is said to by writing a covered call. Otherwise he or she is writing a naked call and will have to buy the underlying asset on the open market should the option be exercised. Iraw the payoff diagram of a covered call *including the value of the owned underlying asset+ and compare it with the payoff of other options.

3alue

/overed /all

'tock -rice

A covered call has the same payoff shape as a put option, but it is shifted upward by the value of the strike price. This is e5uivalent to the combination of a put option and a risk% free bond.

20.

An American option will never be worth less than a !uropean option. !valuate this statement.

This statement is true. An American option has all the rights that a !uropean option has. "n addition, it can be exercised on any date prior to the exercise date. 'ince these additional rights can never have a negative value, an American option will always be worth at least as much as a corresponding !uropean option.

20.'

!xplain why, in the binomial pricing theory, the probabilities of an up move versus a down move are not important.

The replicating portfolio calculated to value the option in this model will have the same value as the option whether the stock goes up or down. The probability of an up move could be LL percent or : percent, and that would not change. The replicating portfolio is not determined by the likelihood of the two possibilitiesDonly the option value in those two cases. That said, the value of the replicating portfolio *and therefore the option+ is affected by the current stock price, which, presumably, would change with the probabilities of up or down stock price moves.

20.)

)ike all other models, the binomial pricing model is a simplification of reality. "n this model, how do we represent high volatility or low volatility of the value of the underlying asset?

The difference between the high and low possible future prices represents volatility. "f these two numbers are relatively close together, that represents low volatility of the value

of the underlying asset. The further apart they are, the higher the volatility the model represents.

20.;

Eow do real options differ from financial options?

7eal options arise from the operations of the company. They generally could not be purchased separately, but they sometimes form an important part of the value of pro6ects available to the firm. They are options on underlying assets that are not publicly traded. >inancial options or traded options are available separately and fre5uently are options on assets that are also publicly traded. As a result, their value is generally easier to estimate *since we have the traded value of the underlying asset+. traded options to manage our risk exposure. e can also use

20.< a.

hat kinds of real options should be considered in the following situations? ingnuts 7 Js is considering two sites for a new factory. One is 6ust large enough for the planned facility, while the other is three times larger. b. /arousel /ruises is purchasing three new cruise ships to be built se5uentially. The first ship will commence construction today and will take one year to build. The second will then be started. /arousel can cancel the order for a given cruise ship at any time before construction begins.

ingnuts 7 Js should consider the option to expand operations. /arousel should consider the option to abandon their order and not take delivery of the additional ships.

20.=

>uture !nterprises is considering a factory that will include an option to expand operations in three years. "f things go well, the anticipated expansion will have a value of <:9 million and will cost <8 million to undertake. "f not, it will have a value of <: million, and so it will not expand. hat additional information would be needed in order

to analy$e this capital budgeting problem using the traditional 4-3 approach that we would not need using option valuation techni5ues?

"n order to use traditional 4-3 techni5ues, we need to know the probability of things going well so that we can estimate the expected cash flows. e will also need to know

how the performance of the overall economy affects these probabilities so that we can estimate an appropriate discount rate for the expected expansion cash flows.

20.>

/orporations fre5uently include employee stock options as a part of the compensation for their managers and sometimes for all their employees. These options allow the holder to buy the stock of the company for a preset price like any other option, but they are usually very long lived, with maturities of :9 years. The goal of stock option plans is to align the incentives of employees and shareholders. current shareholders? hat are the implications of these plans for

'uch plans have the effect of diluting the value of any gains in stock price.

hen the

value of the firm goes up, the options will be exercised and the result will be more people with a claim on the same underlying assets. The value of each claim will be reduced. At

the same time, the ob6ective of the plans is to mitigate the agency problems associated with managers# and employees# incentives. (anagers and employees who have been granted stock options have more to gain when the company does well. They are less likely to be too conservative when deciding which pro6ects the company will pursue. "f the stock option plans achieve their ob6ective, the firm will be worth more than it would have been without the plan, and so there will be more wealth to split up. >inding a good trade%off between these effects is a challenge.

20.10 Nou are a bondholder of A@/ /orp. Jsing option pricing theory, explain what agency concerns you would have if A@/ were in danger of bankruptcy.

The e5uity of a firm can be thought of as a call option on the assets of the firm. "f the firm is close to bankruptcy, you as a bondholder should be concerned that the company will take actions to increase the volatility of the assets by investing in highly risky pro6ects, turn down positive%4-3 pro6ects, and, possibly, try to increase the dividend payouts. All of these actions can increase the value of the e5uity at the expense of the value of the debt holders.

20.11 A bond covenant is a part of a bond contract that restricts the behavior of the firm, barring it from taking certain actions. Jsing the terminology of options, explain why a bond contract might include a covenant preventing the firm from making large dividend payments to its shareholders.

/ash on hand reduces the total volatility of the value of the firm. "f any cash on hand is paid out to shareholders in the form of a large dividend payment, the volatility of the firm will increase and the value of the debt will decrease. "n order to prevent this, bonds often feature covenants restricting the firm to dividend payments no larger than some fraction of current earnings.

20.12 Eow can the insurance policy on a car be viewed as an option?

The insurance policy on a car can be viewed as a put option. "n the extreme case, where your car is totaled, you have the right to put the car to the insurance company for its market value prior to the accident.

&---. :uestions and %roble"s

7.3-C
20.1 Option characteristics2 hat is an option?

3olution2 An option is the right to buy or sell an asset at a prespecified price on or before a prespecified date?

20.2

Option characteristics2 !xplain how the payoff functions differ for the owner *buyer+ and seller of a call option& of a put option.

3olution2 *:+ /all option, hen the value of the underlying asset is below the exercise price, the payoffs for both the buyer and seller of a call option are 9. Once the asset price goes above the exercise price, the payoff for the buyer increases dollar for dollar with the price of the underlying asset, while the payoff for the seller decreases dollar for dollar with the price of the underlying asset. The sum of the payoffs of the buyer and seller of a call option is always 9. *8+ -ut option, hen the value of the underlying asset is above the exercise price, the payoffs for both the buyer and seller of a put option are 9. Once the asset price drops below the exercise

price, the payoff for the buyer increases dollar for dollar with decrease of the price of the underlying asset, while the payoff for the seller decreases dollar for dollar with decrease of the price of the underlying asset. The sum of the payoffs of the buyer and seller of a put option is always 9.

20.

Option payoffs2

hat is the payoff to a call option with a strike price of <B9 if the stock hat if it is <;B?

price at expiration is <A9?

3olution2 "f the stock price is <A9, then the option will not be exercised and the option is worthless. * hy buy for <B9 what you can buy in the market for <A9?+ "f the stock price is <;B, then the option is worth the difference between the price and the strike price, <;B 2 <B9 . <:B.

20.'

Option payoffs2

hat is the payoff to a put option with a strike price of <B9 if the stock hat if it is <;B?

price at expiration is <A9?

3olution2 "f the stock price is <A9, then the option is worth the difference between the strike price and the stock price, <B9 2 A9 . <:9. "f the stock price is <;B, then the option is worthless.

20.)

Option valuation2

hat are the five variables that affect the value of an option, and how

do changes in each of these variables affect the value of a call option?

3olution2 The value of a call option increases as, *:+ /urrent value of the underlying asset increases& *8+ !xercise price decreases& *=+ 3olatility of the value of the underlying asset increases& *A+ Time until the expiration of the option increases& or *B+ 7isk%free rate of interest increases.

20.;

Option valuation2 Assuming nothing else changes, what happens to the value of an option as time passes and the expiration date gets closer?

3olution2 The value of an option declines as time passes.

20.<

Option valuation2

hat does the seller of a put option hope will happen?

3olution2 Ee hopes the option will not be exercised. "n this case, the option will be exercised if the asset value at expiration is lower than the strike price, so he hopes the asset value will rise *or at least will remain above the strike price+.

20.=

Option valuation2

hat is the value of a call option if the stock price is $ero?

hat if

the stock price is extremely high *relative to the strike price+?

3olution2 "f the stock price is $ero, then there is no possibility that the stock will have positive value. Thus the option to buy the stock in the future is worthless. "f the stock price is extremely high compared to the strike price, then there is essentially $ero probability that the stock price will be below the strike price at expiration. The option will always be exercised, and the value of the option is the difference between the current stock price and the present value of the strike price.

20.>

Option valuation2 )ike owners of stock, owners of options can lose no more than the amount they invested. They are far more likely to lose that full amount, but they cannot lose more. Io sellers of options have the same limitation on their losses?

3olution2 4o. The seller of a call option can lose a theoretically unlimited amount of money because the value of the underlying asset can go arbitrarily high. The seller of a put option is limited to losing the amount of the strike price *since that is how much they would lose if the stock price went to $ero+.

20.10 Option valuation2

hat is the value at expiration of a call option with a strike price of

<;B if the stock price is <:? <B9? <;B? <:99? <:,999?

3olution2

The value of the option for any stock price less than <;B *including <: and <B9+ is $ero because the option would not be exercised. hen the stock price is e5ual to the strike

price *<;B in this case+, the option owner does not care whether or not he exercises the option. Ee gains *or loses+ nothing. Again, the option is worth $ero. "f the stock price is higher than the strike price, the option is worth the difference. "f the stock is worth <:99, the option is worth <=B. "f the stock is worth <:,999, the option is worth <L=B.

20.11 Option valuation2 'uppose you have an option to buy a share of A@/ /orp stock for <:99. The option expires tomorrow, and the current price of A@/ /orp is <LB. Eow much is your option worth?

3olution2 Nour option is worth very slightly more than $ero. There is little chance that the stock price will move above <:99 by tomorrow, but the chance is not $ero, so the option still has some value.

20.12 Option valuation2 Nou hold an American option to sell one share of Pyther /o., which expires tomorrow. The strike price of the option is <B9, and the current stock price is <AL. hat is the value of exercising the option today? "f you wanted to sell the option instead, about how much would you expect to receive?

3olution2

The value of exercising today is the difference between the strike price and the stock price, <:. "f you sold the option, you should expect to receive slightly more than that.

20.1

0eal options2

hat is the difference between a financial option and a real option?

3olution2 The underlying asset of a financial option is a financial asset, while the underlying asset of a real option is associated with investment pro6ects.

20.1' 0eal options2 )ist and describe four different types of real options that are associated with investment pro6ects.

3olution2 >our types of real options are associated with investment pro6ects, *:+ Options to defer investment, the ability to defer an investment decision until information on its future cash flows is less uncertain. *8+ Options to make follow%on investments, the possibility to exploit future business opportunities that will not otherwise be available if the investment is not taken. *=+ Options to change operations, the flexibility in changing operations as business conditions change if the investment is taken. *A+ Options to abandon pro6ects, the ability to terminate the pro6ect at a smaller loss if things do not go as well as anticipated.

20.1) .gency costs2 Eow are options related to the agency costs of debt and e5uity?

3olution2 Agency costs arise since the incentives of shareholders are different from those of the debt holders. !5uity and debt claims are like different types of options on the firm. The payoff function for the stockholders looks exactly like that for the owner of a call option where the exercise price is the amount owed on the loan and the underlying asset is the firm itself. The payoff function for the lenders looks like that for the seller of a put option, where the exercise price is the amount of the loan and the underlying asset is the firm itself. The different payoff functions create different incentives for shareholders and debt holders. >or example, shareholders are likely to pursue more risky pro6ects. The increased volatility of cash flows increases the expected payout for the holder of a call option, the shareholder, and decreases the expected payout for the seller of a put option, the debt holder.

-!1*05*D-.1*
20.1; Option valuation2 'uppose that you own a call option and a put option on the same stock and that these options have the same exercise price. !xplain how the relative values of these two options will change as the stock price increases or decreases.

3olution2 hen stock prices increase, the value of the call option increases and the value of the put option decreases& when stock prices decrease, the value of the call option decreases and

the value of the put option increases. The further the stock price is from the exercise price, the more valuable the combination of these options becomes.

20.1< Other options2 A callable bond is a bond that can be bought back by the bond issuer before maturity for some prespecified price *normally face value+ at the discretion of the bondholder. Eow would you go about finding the value of such a bond? be worth more or less than an e5uivalent, noncallable bond? ould the bond

3olution2 The purchaser of a callable bond is simultaneously selling the issuer a call option on that bond. The value would be e5ual to the value of the straight bond minus the value of the option. This is clearly less than the value of the *noncallable+ bond by itself.

20.1= Other options2 A convertible bond is a bond that can be exchanged for stock at the discretion of the bondholder. Eow would you go about finding the value of such a bond? ould the bond be worth more or less than an e5uivalent, nonconvertible bond?

3olution2 A convertible bond is e5uivalent to a combination of a nonconvertible bond and a call option on the stock, where the strike price of the option is the value of the bond. @ecause the value of the bond may change along with the value of the stock, this is not a straightforward problem, but the value would be e5ual to the value of the straight bond

plus the value of the option. This is clearly more than the value of the *nonconvertible+ bond by itself.

20.1> Option valuation2 The seller of an option can never make any money from the change in the value of the underlying asset. Ee or she can only hope that the option will not be exercised and that no money will be lost. Civen that this is the case, why do people write options?

3olution2 Option writers receive the value of the option up front. The money the seller receives by selling the bond is referred to as the bond premium. This payment compensates them for the obligation they are taking on. . 20.20 Option valuation2 The stock of 'ocrates (otors is currently trading for <A9 and will either rise to <B9 or fall to <=B in one month. The risk%free rate for one month is :.B percent. hat is the value of a one%month call option with a strike price of <A9?

3olution2

'tock *1+ Today <A9

7isk%>ree *N+ <:

Option ???

!xpiration <=B <B9 <:.9:B <:.9:B <9 <:9

These two e5uations define our portfolio, <:9 . *<B9 G 1+ 0 *<:.9:B G N+ <9 . *<=B G 1+ 0 *<:.9:B G N+ and the solution is 1 . 8K= and N . %<88.LL. That is, we borrow <88.LL and buy two% thirds of a share of 'ocrates (otors at a cost of <A9.99 per share. The total net cost of this portfolio is <A9.99 G *8K=+ 2 88.LL . <=.;F and this is the value of the option.

20.21 Option valuation2 Again assume that the price of 'ocrates (otors stock will either rise to <B9 or fall to <=B in one month and that the risk%free rate for one month is :.B percent. Eow much is an option with a strike price of <A9 worth if the current stock price is instead <AB?

3olution2 The replicating portfolio of 1 . 8K= and N . %<88.LL does not depend on the current stock price and so would not change. The value of that portfolio would now be <AB G *8K=+ 2 <88.LL . <H.9:, and this is the value of the option.

20.22 Option valuation2 Assume that the stock of 'ocrates (otors is currently trading for <A9 and will either rise to <B9 or fall to <=B in one month. The risk%free rate for one month is :.B percent. hat is the value of a one%month call option with a strike price of <8B?

3olution2

'tock *1+ Today <A9

7isk%>ree *N+ <:

Option ???

!xpiration <=B <B9 <:.9:B <:.9:B <:9 <8B

These two e5uations define our portfolio, <8B . *<B9 G 1+ 0 *<:.9:B G N+ <:9 . *<=B G 1+ 0 *<:.9:B G N+ and the solution is X . : and # . %<8A.;=. That is, we borrow <8A.;= and buy : share of 'ocrates (otors at a cost of <A9. The total net cost of this portfolio is <A9 2 <8A.;= . <:B.=H, and this is the value of the option.

20.2

Option valuation2 Nou are considering a three%month put on

ing and A -rayer

/onstruction. The company currently trades for <:9 per share and will either rise to <:B or fall to <H in three months. The risk%free rate for three months is 8 percent. appropriate price for a put with a strike price or <L? hat is the

3olution2 "f the stock rises to <:B, then the option will not be exercised and its payoff will be <9. "f the stock falls to <H, the option will be exercised and its value will be the difference between the strike price and the stock price, <8.

'tock *1+ Today <:9

7isk%>ree *N+ <:

Option ???

!xpiration <H <:B <:.98 <:.98 <8 <9

The formulas that define the replicating portfolio are, <8 . *<H G 1+ 0 *<:.98 G N+ <9 . *<:B G 1+ 0 *<:.98 G N+ and the solution is 1 . %<9.8B and N . <=.;F. That is, we will short sell one%fourth of a share of the stock, receiving <8.B, and we will lend <=.;F at the risk%free rate. *'hort selling is the process of borrowing an asset that you do not own and selling, with the promise that at some time in the future you will buy it back and return it to its owner.+ The net cost is <=.;F 2 <8.B9 . <:.:F. This is the value of the option.

20.2' Option valuation2 Nou hold a !uropean put option on Tubes, "nc., with a strike price of <:99. Things haven#t been going too well for Tubes. The current stock price is <8, and you think that it will either rise to <= or fall to <:.B at the expiration of your option. The appropriate risk%free rate is B percent. hat is the value of the option? "f this were an

American option, would it be worth more?

3olution2 4ote that this option will be exercised regardless.

'tock *1+ Today <8.9

7isk%>ree *N+ <:

Option ???

!xpiration <:.B <=.9 <:.9B <:.9B <LF.B <LH

The formulas that define the replicating portfolio are, <LF.B . *<:.B G 1+ 0 *<:.9B G N+ <LH . *<= G 1+ 0 *<:.9B G N+ and the solution is 1 . %: and N . <LB.8A. That is, we will short sell : of a share of the stock, receiving <8, and we will lend <LB.8A at the risk%free rate. The net cost is <LB.8A 2 <8.99 . <L=.8A. This is the value of the *!uropean+ option. "f this were an American option, we could exercise today if we wanted. e would

want to do so if the value of exercising today was greater than the value of the option.

!xercising today would allow us to sell for <:99 something worth <8, a gain of <LF. This is more than <L=.8A. The American option is worth more.

20.2) Other options2 A golden parachute is a part of a manager#s compensation package that makes a large lump%sum payment in the event that the manager is fired *or loses his or her 6ob in a merger, for example+. This seems ill%advised to most people first hearing about it. !xplain how a golden parachute can help reduce agency costs between stockholders and managers.

3olution2 (anagers have incentives to avoid bankruptcy or even underperformance because the personal cost to them is 5uite high. As a result they may choose to avoid high risk investments even if those investments are highly positive 4-3. The costs to the manager if the pro6ect goes badly outweigh the benefits if it goes well. Eowever, stockholders want the manager to take positive%4-3 pro6ects, even if they are risky. Colden parachutes help to solve this problem by reducing the costs to the manager associated with poor performance or bankruptcy. The manager faces a payoff structure like the seller of an option. Colden parachutes serve to reduce the volatility of that option and therefore to reduce the value of that option.

.D&.!C*D
20.2; /onsider the following payoff diagram.

3alue

<:9

<A9

<B9

<;9

'tock price

>ind a combination of calls, puts, risk%free bonds, and stock that has this payoff. *Nou need not use all of these, and there are many possible solutions.+

3olution2 One possible solution would consist of four options, *a+ @uy a call with a strike of <B9. *b+ @uy a put with a strike of <B9. *c+ 'ell a put with a strike of <A9. *s+ 'ell a call with a strike of <;9. "f the stock price at expiration is below <A9, then neither call will be exercised, but both puts will be. e will be forced to buy the stock for <A9 because of option c, but we will

be able to sell it for <B9, using option b.. Our net gain will be <:9. "f the stock price is between <A9 and <B9, the only option to be exercised will be option b, and we will gain the difference between <B9 and the stock price.

"f the stock price is between <B9 and <;9, the only option to be exercised will be a call option and we will gain the difference between the stock price and <B9. "f the stock price is above <;9, then neither put will be exercised, but both calls will be. e will be able to buy the stock for <B9 using option a, but we will be forced to

sell it for <;9 by the owner of option d. Our net gain will be <:9.

20.2< /onsider the payoff structures of the following two portfolios, a. @uying a call option on one share in one month at a strike price of <B9 and saving the present value of <B9 *so that at expiration it will have grown to <B9 with interest+. b. @uying a put option on one share in one month at a strike price of <B9 and buying one share of stock. hat conclusion can you draw about the relation between call prices and put prices?

3olution2 The payoff of these two portfolios is identical. "n the first case, if the stock price is below <B9 at expiration, you will not exercise and you will be left with <B9. "f it is above <B9, you will exercise and you will have a share of stock *whatever it is worth+. "n the second case, if the price is below <B9, you will exercise your put option and get <B9 for your share of stock. "f it is above <B9, you will not exercise and you will retain your share of stock *whatever it is worth+. >rom this, we can see that the value of the two portfolios today must be the same. That is, / 0 O K *: 0 7rf+ . - 0 '

where / is the value of a call, - is the value of a put, both options have a strike price O and the same expiration, ' is the current value of the stock and 7rf is the risk%free interest rate. "f we know the value of a call *and the current stock price and interest rate+, we can calculate the value of a put. This relation is call put-call parit". 4ote that this relation is not dependent on any option pricing model.

20.2= One way to extend the binomial pricing model is by including multiple time periods. 'uppose 'plittime, "nc., is currently trading for <:99 per share. "n one month the price will either increase by <:9 *to <::9+ or decrease by <:9 *to <L9+. The following month will be the same. The price will either increase by <:9 or decrease by <:9. 4ote that in two months, the price could be <:89, <:99, or <F9. The risk%free rate is : percent per month. >ind the value today of an option to buy one share of 'plittime in two months for a strike price of <:9B. *$int% To do this, first find the value of the option at each of the two possible one%month prices. Then use those values as the payoffs at one month and find the value today.+

3olution2 "f the price of 'plittime goes from <:99 to <L9 during the first month, then this option will never be exercised because the highest price to which 'plittime could rise by two months is <:99, which is lower than the strike price of <:9B. Therefore, the value of the option in the down case is <9. "f the price rises to <::9 in the first month, then the payoff of the option will be either <:B *if the price continues to rise to <:89+ or <9 *if the price falls back to <:99+.

'tock *1+ One month <::9

7isk%>ree *N+ <:

Option ???

!xpiration <:99 <:89 <:.9: <:.9: <9 <:B

These two e5uations define our portfolio, <:B . <:89 G 1 0 <:.9: G N <9 . <:99 G 1 0 <:.9: G N The solution is 1 . 9.HB shares and N . %<HA.8;. The value of this portfolio, and therefore the value of the option at this point, is <F.8A. *9.HB G <::9 2 <HA.8;+. 4ow we are ready to calculate the value of the option today using <9 and <F.8A as the one%month option payoffs.

'tock *1+ Today <:99

7isk%>ree *N+ <:

Option ???

One month <L9 <::9 <:.9: <:.9: <9 <F.8A

4ow the e5uations that define our portfolio are <F.8A . <::9 G 1 0 <:.9: G N <9 . <L9 G 1 0 <:.9: G N

The solution is 1 . 9.A:8 and N . %<=;.H:. The portfolio value is <A.B9, and this is the value of the option.

20.2> 'pinThe heel /o. current has assets currently worth <:9 million in the form of one%year risk%free bonds that will return :9 percent. The company has debt with a face value of <B.B million due in one year. *4o interest payments will be made.+ The stockholders decided to sell <F million of the risk%free bonds and to invest the money in a very risky venture. This venture consists of (r. illiam Oid taking the money now and, in one year,

flipping a coin. "f it comes up heads, (r. Oid will pay 'pinThe heel <:H.; million. "f it is tails, 'pinThe heel gets nothing. *4otice that this is a $ero 4-3 investment.+ a. hat is the value of the debt and e5uity before they make this investment?

b. Jsing the binomial pricing model, with the payoff to the e5uity holders representing the option and the assets of the company representing the underlying asset, estimate the value of the e5uity after they make the investment. c. hat is the new value of the debt after the investment?

3olution2 a. The firm is certain to have the <B.B million owed to the debt holders in one year, so the correct discount rate for the debt is the risk%free rate, :9 percent. Thus the value today of the debt is the present value of the debt at the risk%free rate, <B.B million K :.: . <B million. The value of the e5uity is therefore <:9 million 2 <B million . <B million.

b. The payoffs of the option *the e5uity+, the underlying *the firm+, and the risk%free bond are,

>irm Today <:9

7isk%>ree *N+ <:

!5uity ???

One year <8.8 <:L.F <:.: <:.: <9

<:A. =

4ote that the payoff of <:A.= for the option in the up case comes from the <:L.F million less the <B.B million they will pay the bondholders. "n the down case, there is not enough money to pay the bondholders what they are owed, so the bondholders will receive the entire <8.8 million value of the firm and the e5uity holders get nothing. The e5uations are,

<:A.= . <:L.F G 1 0 <:.: G N <9 . <8.8 G 1 0 <:.: G N and the solution is 1 . 9.F:8B and N . %<:.;8B. The value of this portfolio is <;.B million. This is the new value of the e5uity. c. The current value of the firm did not change *this was a $ero 4-3 pro6ect+ and remains at <:9 million. "f the e5uity has increased in value to <;.B million, the debt has decreased in value to <=.B million.

20. 0 The payoff function for straight debt looks like that for the seller of a put option. /onvertible debt is straight debt plus a call option on a firm#s stock. Eow does the addition of a call option to straight debt affect the concern that lenders have about the stockholders seeking riskier pro6ects *the asset substitution problem+, and why?

3olution2 "t mitigates this concern because the lenders will benefit through the call option from increased volatility in the value of the firm. Eow much a conversion option mitigates this concern depends on the specific characteristics of the option.

3a"ple 1est %roble"s

20.1 Iraw the payoff diagram representing the payoff for a combination of buying a call with a strike price of <A9 and selling a call with a strike price of <B9. such an option hope would happen to the stock price? hat would the buyer of

3olution2 The payoff diagram would look like this,

3alue

<:9

<A9

<B9

'tock price

This is called a collar. The buyer hopes that the stock price will go up *above <A9+. /ollars are used to limit the cost of the option position. They give up the gain for large moves in exchange for lower cost up front.

20.2

Of the five variables identified as affecting the value of an option, which will have the opposite impact on the value of a put as they do on the value of a call? That is, for which variables will a given change increase the value of a call and decrease the value of a put *or vice versa+?

3olution2 There are three such variables. An increase in the value of the underlying asset will increase the value of a call and decrease the value of a put. An increase in the strike price of the option will decrease the value of a call and increase the value of a put. An increase in the risk%free interest rate will increase the value of a call and decrease the value of a put. @oth of the other two variables, the time to expiration and the volatility of the value of the underlying asset, affect the value of puts and calls in the same direction.

20.

hat kinds of real options are being described? a. >red#s /heap /ars buys the empty field ad6acent to its car lot. b. (idway through construction, (ini(ax, "nc., stops construction of an office building that it planned to use as a corporate head5uarters. c. (a6or Ieals, a discount retailer, opens a new store in (exico, its first.

3olution2 a. >red is buying the option to expand his business. b. (ini(ax is exercising its option to abandon the pro6ect.

c. (a6or Ieals *in addition to other things+ is gaining the option to expand its (exican presence in the future.

20.'

"f you fail to account for the real options available in a given pro6ect, what error might you make in your capital budgeting decision?

3olution2 Nou might re6ect a pro6ect that is positive 4-3. Options are a valuable part of a pro6ect that contains them. @y including their value, we increase our estimate of the 4-3 of the pro6ect, possibly from negative to positive.

20.)

'uppose you are a corn farmer. Assuming that there is an active market in corn derivatives *futures and options+, what trades might you want to use to protect yourself against falling corn prices? hat would be the cost of using them?

3olution2 Nou could buy puts on corn. This would allow you to benefit from upward movements in corn prices while providing a minimum price at which you would be sure to be able to sell. The downside is the immediate cost of buying the option.