Chapter 20 - Options Markets: Introduction

Chapter 20 - Options Markets: Introduction
CHAPTER20:OPTIONSMARKETS:INTRODUCTION
PROBLEMSETS
1.
Optionsprovidenumerousopportunitiestomodifytheriskprofileofaportfolio.The
simplestexampleofanoptionstrategythatincreasesriskisinvestinginanalloptions
portfolioofatthemoneyoptions(asillustratedinthetext).Theleverageprovidedby
optionsmakesthisstrategyveryrisky,andpotentiallyveryprofitable.Anexampleofa
riskreducingoptionsstrategyisaprotectiveputstrategy.Here,theinvestorbuysaput
onanexistingstockorportfolio,withexercisepriceoftheputnearorsomewhatless
thanthemarketvalueoftheunderlyingasset.Thisstrategyprotectsthevalueofthe
portfoliobecausetheminimumvalueofthestockplusputstrategyistheexerciseprice
oftheput.
2.
Buyingaputoptiononanexistingportfolioprovidesportfolioinsurance,whichis
protectionagainstadeclineinthevalueoftheportfolio.Intheeventofadeclinein
value,theminimumvalueoftheputplusstockstrategyistheexercisepriceoftheput.
Aswithanyinsurancepurchasedtoprotectthevalueofanasset,thetradeoffaninvestor
facesisthecostoftheputversustheprotectionagainstadeclineinvalue.Thecostof
theprotectionisthecostofacquiringtheprotectiveput,whichreducestheprofitthat
resultsshouldtheportfolioincreaseinvalue.
3.
Aninvestorwhowritesacallonanexistingportfoliotakesacoveredcallposition.If,at
expiration,thevalueoftheportfolioexceedstheexercisepriceofthecall,thewriterof
thecoveredcallcanexpectthecalltobeexercised,sothatthewriterofthecallmust
selltheportfolioattheexerciseprice.Alternatively,ifthevalueoftheportfolioisless
thantheexerciseprice,thewriterofthecallkeepsboththeportfolioandthepremium
paidbythebuyerofthecall.Thetradeoffforthewriterofthecoveredcallisthe
premiumincomereceivedversusforfeitofanypossiblecapitalappreciationabovethe
exercisepriceofthecall.
20-1
4.
Anoptionisoutofthemoneywhenexerciseoftheoptionwouldbeunprofitable.Acall
optionisoutofthemoneywhenthemarketpriceoftheunderlyingstockislessthanthe
exercisepriceoftheoption.Ifthestockpriceissubstantiallylessthantheexercise
price,thenthelikelihoodthattheoptionwillbeexercisedislow,andfluctuationsinthe
marketpriceofthestockhaverelativelylittleimpactonthevalueoftheoption.This
sensitivityoftheoptionpricetochangesinthepriceofthestockiscalledtheoptions
delta,whichisdiscussedindetailinChapter21.Foroptionsthatarefaroutofthe
money,deltaisclosetozero.Consequently,thereisgenerallylittletobegainedorlost
bybuyingorwritingacallthatisfaroutofthemoney.(Asimilarresultappliestoaput
optionthatisfaroutofthemoney,withstockpricesubstantiallygreaterthanexercise
price.)
Acallisinthemoneywhenthemarketpriceofthestockisgreaterthantheexercise
priceoftheoption.Ifstockpriceissubstantiallygreaterthanexerciseprice,thenthe
priceoftheoptionapproachestheorderofmagnitudeofthepriceofthestock.Also,
sincesuchanoptionisverylikelytobeexercised,thesensitivityoftheoptionpriceto
changesinstockpriceapproachesone,indicatingthata$1increaseinthepriceofthe
stockresultsina$1increaseinthepriceoftheoption.Underthesecircumstances,the
buyerofanoptionlosesthebenefitoftheleverageprovidedbyoptionsthatarenearthe
money.Consequently,thereislittleinterestinoptionsthatarefarintothemoney.
5.
a.
b.
c.
d.
e.
f.
6.
Calloption,X=$100.00
Putoption,X=$100.00
Putoption,X=$105.00
Putoption,X=$110.00
Cost
$7.65
$2.53
$4.40
$4.40
$2.30
$7.40
Payoff
$5.00
$0.00
$0.00
$0.00
$0.00
$5.00
Profit
$2.65
$2.53
$4.40
$4.40
$2.30
$2.40
Intermsofdollarreturns,basedona$10,000investment:
StockPrice
Allstocks(100shares)
Alloptions(1,000options)
Bills+100options
PriceofStock6MonthsfromNow
$80
$100
$110
$120
$8,000 $10,000 $11,000 $12,000
$0
$0
$10,000 $20,000
$9,360 $9,360 $10,360 $11,360
Intermsofrateofreturn,basedona$10,000investment:
StockPrice
Allstocks(100shares)
Alloptions(1,000options)
PriceofStock6MonthsfromNow
$80
$100
$110
$120
20%
0%
10%
20%
100%
100%
0%
100%
20-2
Bills+100options
6.4%
6.4%
20-3
3.6%
13.6%

Rate of return (%)
100
All options
All stocks
Bills plus options
100
110
6.4
ST
100
7.
a.
Fromputcallparity:
P=CS0+[X/(1+rf)T]=10100+[100/(1.10)1/4]=$7.65
b. Purchaseastraddle,i.e.,bothaputandacallonthestock.Thetotalcostofthe
straddleis:$10+$7.65=$17.65
Thisistheamountbywhichthestockwouldhavetomoveineitherdirectionfor
theprofitonthecallorputtocovertheinvestmentcost(notincludingtimevalue
ofmoneyconsiderations).Accountingfortimevalue,thestockpricewouldhave
tomoveineitherdirectionby:$17.651.101/4=$18.08
8.
a.
Fromputcallparity:
C=P+S0[X/(l+rf)T]=4+50[50/(1.10)1/4]=$5.18
b.
Sellastraddle,i.e.,sellacallandaputtorealizepremiumincomeof:
$5.18+$4=$9.18
Ifthestockendsupat$50,bothoftheoptionswillbeworthlessandyourprofit
willbe$9.18.Thisisyourmaximumpossibleprofitsince,atanyotherstock
price,youwillhavetopayoffoneitherthecallortheput.Thestockpricecan
moveby$9.18ineitherdirectionbeforeyourprofitsbecomenegative.
20-4
c.
Buythecall,sell(write)theput,lend:$50/(1.10)1/4
Thepayoffisasfollows:
Position
ImmediateCF
Call(long)
Put(short)
C=5.18
P=4.00
50
48.82
Lendingposition
1.101 / 4
CP+
50
Total
50.00
1.101 / 4
CFin3months
STX
ST>X
0
ST50
(50ST)
0
50
50
ST
ST
Bytheputcallparitytheorem,theinitialoutlayequalsthestockprice:
S0=$50
Ineitherscenario,youendupwiththesamepayoffasyouwouldifyouboughtthe
stockitself.
9.
a.
b.
Outcome
Stock
Put
Total
STX
ST+D
XST
X+D
ST>X
ST+D
0
ST+D
Outcome
Call
Zeros
Total
STX
0
X+D
X+D
ST>X
STX
X+D
ST+D
ThetotalpayoffsforthetwostrategiesareequalregardlessofwhetherSTexceeds
X.
c.
Thecostofestablishingthestockplusputportfoliois:S0+P
Thecostofestablishingthecallpluszeroportfoliois:C+PV(X+D)
Therefore:
S0+P=C+PV(X+D)
Thisresultisidenticaltoequation20.2.
20-5
10.
a.
ST<X1
X1STX2
X2<STX3
X3<ST
Longcall(X1)
Short2calls(X2)
Longcall(X3)
0
0
0
STX1
0
0
STX1
2(STX2)
0
STX1
2(STX2)
STX3
Total
STX1
2X2X1ST
(X2X1)(X3X2)=0
Position
Payof
X2 X1
X1
X2
ST
X3
b.
Position
ST<X1
Buycall(X2)
Buyput(X1)
0
X1ST
Total
X1ST
X1STX2
X2X2XX
2
0
X2<ST
STX2
0
STX2
Payof
X1
X1
ST
X2
20-6
11.
ST<X1
X1STX2
X2<ST
Buycall(X2)
Sellcall(X1)
0
0
XX
02
(STX1)
STX2
(STX1)
Total
X1ST
X1X2
X1
X2
Position
Payof
0
Payof
(X2 X1)
12.
a.
ST
Bywritingcoveredcalloptions,Jonesreceivespremiumincomeof$30,000.If,in
January,thepriceofthestockislessthanorequalto$45,thenJoneswillhavehis
stockplusthepremiumincome.Butthemosthecanhaveatthattimeis($450,000
+$30,000)becausethestockwillbecalledawayfromhimifthestockprice
exceeds$45.(Weareignoringhereanyinterestearnedoverthisshortperiodof
timeonthepremiumincomereceivedfromwritingtheoption.)Thepayoff
structureis:
Stockprice
lessthan$45
greaterthan$45
Portfoliovalue
10,000timesstockprice+$30,000
$450,000+$30,000=$480,000
ThisstrategyofferssomeextrapremiumincomebutleavesJonessubjectto
substantialdownsiderisk.Atanextreme,ifthestockpricefelltozero,Jones
wouldbeleftwithonly$30,000.Thisstrategyalsoputsacaponthefinalvalueat
$480,000,butthisismorethansufficienttopurchasethehouse.
b.
Bybuyingputoptionswitha$35strikeprice,Joneswillbepaying$30,000in
premiumsinordertoinsureaminimumlevelforthefinalvalueofhisposition.
Thatminimumvalueis:($3510,000)$30,000=$320,000
Thisstrategyallowsforupsidegain,butexposesJonestothepossibilityofa
moderatelossequaltothecostoftheputs.Thepayoffstructureis:
Stockprice
lessthan$35
greaterthan$35
Portfoliovalue
$350,000$30,000=$320,000
10,000timesstockprice$30,000
20-7
c.
Thenetcostofthecollariszero.Thevalueoftheportfoliowillbeasfollows:
Stockprice
lessthan$35
between$35and$45
greaterthan$45
Portfoliovalue
$350,000
10,000timesstockprice
$450,000
Ifthestockpriceislessthanorequalto$35,thenthecollarpreservesthe
$350,000principal.Ifthepriceexceeds$45,thenJonesgainsuptoacapof
$450,000.Inbetween$35and$45,hisproceedsequal10,000timesthestock
price.
Thebeststrategyinthiscasewouldbe(c)sinceitsatisfiesthetworequirements
ofpreservingthe$350,000inprincipalwhileofferingachanceofgetting
$450,000.Strategy(a)shouldberuledoutsinceitleavesJonesexposedtothe
riskofsubstantiallossofprincipal.
Ourrankingwouldbe:(1)strategyc;(2)strategyb;(3)strategya.
13.
a.,b. TheExcelspreadsheetforbothparts(a)and(b)isshownonthenextpage,andthe
profitdiagramsareonthefollowingpage.
14.
Thefarmerhastheoptiontosellthecroptothegovernmentforaguaranteedminimum
priceifthemarketpriceistoolow.IfthesupportpriceisdenotedPSandthemarket
pricePmthenthefarmerhasaputoptiontosellthecrop(theasset)atanexerciseprice
ofPSevenifthepriceoftheunderlyingasset(Pm)islessthanPS.
15.
Thebondholdershave,ineffect,madealoanwhichrequiresrepaymentofBdollars,
whereBisthefacevalueofbonds.If,however,thevalueofthefirm(V)islessthanB,
theloanissatisfiedbythebondholderstakingoverthefirm.Inthisway,the
bondholdersareforcedtopayB(inthesensethattheloaniscancelled)inreturnfor
anassetworthonlyV.ItisasthoughthebondholderswroteaputonanassetworthV
withexercisepriceB.Alternatively,onemightviewthebondholdersasgivingtheright
totheequityholderstoreclaimthefirmbypayingofftheBdollardebt.The
bondholdershaveissuedacalltotheequityholders.
16.
Themanagerreceivesabonusifthestockpriceexceedsacertainvalueandreceives
nothingotherwise.Thisisthesameasthepayofftoacalloption.
20-8
SpreadsheetforProblem13:
Stock Prices
Beginning Market Price
Ending Market Price
116.5
130
Ending
Buying Options:
Call Options Strike
110
120
130
140
Price
22.80
16.80
13.60
10.30
Payoff
20.00
10.00
0.00
0.00
Profit
-2.80
-6.80
-13.60
-10.30
Return %
-12.28%
-40.48%
-100.00%
-100.00%
Put Options Strike

110
120
130
140
Price
12.60
17.20
23.60
30.50
Payoff
0.00
0.00
0.00
10.00
Profit
-12.60
-17.20
-23.60
-20.50
Return %
-100.00%
-100.00%
-100.00%
-67.21%
Straddle
110
120
130
140
Price
35.40
34.00
37.20
40.80
Payoff
20.00
10.00
0.00
10.00
Profit
-15.40
-24.00
-37.20
-30.80
Return %
-43.50%
-70.59%
-100.00%
-75.49%
20-9
Stock Price
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
X 130 Straddle
Profit
-37.20
42.80
32.80
22.80
12.80
2.80
-7.20
-17.20
-27.20
-37.20
-27.20
-17.20
-7.20
2.80
12.80
22.80
32.80
42.80
Selling Options:
Call Options Strike
110
120
130
140
Price
22.80
16.80
13.60
10.30
Payoff
-20
-10
0
0
Profit
2.80
6.80
13.60
10.30
Return %
12.28%
40.48%
100.00%
100.00%
110
120
130
140
Price
12.60
17.20
23.60
30.50
Payoff
0
0
0
10
Profit
12.60
17.20
23.60
40.50
Return %
100.00%
100.00%
100.00%
132.79%
Price
Payoff
Profit
16.80
13.60
10.00
0
10.00
Put Options Strike
Money Spread
Bullish Spread
Purchase 120 Call
Sell 130 Call
Combined Profit
-6.80
13.60
6.80
Ending
Stock Price
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
Bullish
Spread
Profitdiagramforproblem13:
Spreads and Straddles
50.00
40.00
30.00
20.00
130 Straddle
10.00
Bullish Spread
0.00
0
50
100
150
-10.00
-20.00
-30.00
-40.00
-50.00
Stock Price
20-10
200
250
6.80
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
-3.2
6.8
6.8
6.8
6.8
6.8
6.8
6.8
6.8
6.8
17.
a.
Position
Writecall,X=$105
Writeput,X=$100
Total
ST<100
100ST105
ST>105
0
(100ST)
0
0
(ST105)
0
ST100
105ST
Payof
100
105
ST
Write put
b.
Write call
Proceedsfromwritingoptions:
Call:
$4.40
Put:
$2.53
Total: $6.93
IfIBMsellsat$103ontheoptionexpirationdate,bothoptionsexpireoutofthe
money,andprofit=$6.93.IfIBMsellsat$110ontheoptionexpirationdate,the
callwrittenresultsinacashoutflowof$5atexpiration,andanoverallprofitof:
$6.93$5.00=$1.93
c.
Youbreakevenwheneithertheputorthecallresultsinacashoutflowof$6.93.
Fortheput,thisrequiresthat:
$6.93=$100.00STST=$93.07
Forthecall,thisrequiresthat:
$6.93=ST$105ST=$111.93
d.
TheinvestorisbettingthatIBMstockpricewillhavelowvolatility.Thisposition
issimilartoastraddle.
20-11
18.
Theputwiththehigherexercisepricemustcostmore.Therefore,thenetoutlayto
establishtheportfolioispositive.
Position
Writeput,X=$90
Buyput,X=$95
Total
ST<90
90ST95
ST>95
(90ST)
95ST
0
95ST
0
0
95ST
Thepayoffandprofitdiagramis:
19.
BuytheX=62put(whichshouldcostmorebutdoesnot)andwritetheX=60put.
Sincetheoptionshavethesameprice,yournetoutlayiszero.Yourproceedsat
expirationmaybepositive,butcannotbenegative.
Position
Buyput,X=$62
Writeput,X=$60
Total
ST<60
60ST62
ST>62
62ST
(60ST)
62ST
0
0
0
62ST
Payof = Profit (because net investment = 0)

2
0
60
ST
62
20-12
20.
ThefollowingpayofftableshowsthattheportfolioisrisklesswithtimeTvalueequalto
$10:
Position
ST10
ST>10
Buystock
Writecall,X=$10
Buyput,X=$10
ST
0
10ST
ST
(ST10)
0
10
10
Total
Therefore,theriskfreerateis:($10/$9.50)1=0.0526=5.26%
21.
a.,b.
Position
Buyput,X=$110
Writeput,X=$100
Total
ST<100
100ST110
ST>110
110ST
(100ST)
110ST
0
0
0
10
110ST
Thenetoutlaytoestablishthispositionispositive.Theputyoubuyhasahigher
exercisepricethantheputyouwrite,andthereforemustcostmorethantheput
thatyouwrite.Therefore,netprofitswillbelessthanthepayoffattimeT.
10
Payof
0
100
c.
110
ST
Profit
Thevalueofthisportfoliogenerallydecreaseswiththestockprice.Therefore,its
betaisnegative.
20-13
22.
a.
Joesstrategy
Position
Cost
Payoff
ST400
ST>400
Stockindex
Putoption,X=$400
400
20
ST
400ST
ST
0
Total
420
400
ST
20
ST420
Profit=payoff$420
Sallysstrategy
Position
Cost
Payoff
ST390
ST>390
Stockindex
Putoption,X=$390
400
15
ST
390ST
ST
0
Total
415
390
ST
25
ST415
Profit=payoff$415
Profit
Sally
390
400
Joe
ST
-20
-25
b.
Sallydoesbetterwhenthestockpriceishigh,butworsewhenthestockpriceis
low.ThebreakevenpointoccursatST=$395,whenbothpositionsprovidelosses
of$20.
c.
Sallysstrategyhasgreatersystematicrisk.Profitsaremoresensitivetothevalueof
thestockindex.
20-14
23.
a.,b. (Seegraphbelow)
Thisstrategyisabearspread.Initialproceeds=$9$3=$6
Thepayoffiseithernegativeorzero:
ST<50
50ST60
ST>60
Buycall,X=$60
Writecall,X=$50
0
0
0
(ST50)
ST60
(ST50)
Total
(ST50)
10
Position
c.
Breakevenoccurswhenthepayoffoffsetstheinitialproceedsof$6,whichoccurs
atstockpriceST=$56.Theinvestormustbebearish:thepositiondoesworse
whenthestockpriceincreases.
24.
60
50
ST
-4
Profit
-10
Payof
Buyashareofstock,writeacallwithX=$50,writeacallwithX=$60,andbuyacall
withX=$110.
ST<50
50ST60
60<ST110
ST>110
Buystock
Writecall,X=$50
Writecall,X=$60
Buycall,X=$110
ST
0
0
0
ST
(ST50)
0
0
ST
(ST50)
(ST60)
0
ST
(ST50)
(ST60)
ST110
Total
ST
50
110ST
Position
Theinvestorismakingavolatilitybet.Profitswillbehighestwhenvolatilityislowand
thestockpriceSTisbetween$50and$60.
20-15
25.
a.
Position
ST780
ST>780
Buystock
Buyput
ST
780ST
ST
0
780
ST
ST840
ST>840
Buycall
BuyTbills
0
840
ST840
840
Total
840
ST
Total
Position
Payof
Bills plus calls
840
780
Protective put strategy
ST
b.
780
840
ThebillspluscallstrategyhasagreaterpayoffforsomevaluesofSTandnevera
lowerpayoff.Sinceitspayoffsarealwaysatleastasattractiveandsometimes
greater,itmustbemorecostlytopurchase.
20-16
c.
Theinitialcostofthestockplusputpositionis:$900+$6=$906
Theinitialcostofthebillspluscallpositionis:$810+$120=$930
Stock
+Put
Payoff
Profit
ST=700
700
80
780
126
ST=840
840
0
840
66
ST=900
900
0
900
6
ST=960
960
0
960
54
840
0
840
90
840
0
840
90
840
60
900
30
840
120
960
+30
Bill
+Call
Payoff
Profit
Profit
Protective put
Bills plus calls
780
840
ST
-90
-126
26.
d.
Thestockandputstrategyisriskier.Thisstrategyperformsworsewhenthe
marketisdownandbetterwhenthemarketisup.Therefore,itsbetaishigher.
e.
Parityisnotviolatedbecausetheseoptionshavedifferentexerciseprices.Parity
appliesonlytoputsandcallswiththesameexercisepriceandexpirationdate.
Accordingtoputcallparity(assumingnodividends),thepresentvalueofapaymentof
$105canbecalculatedusingtheoptionswithFebruaryexpirationandexercisepriceof
$105.
PV(X)=S0+PC
PV($105)=$104.69+$4.40$4.40=$104.69
27.
Fromputcallparity:
CP=S0X/(l+rf)T
Iftheoptionsareatthemoney,thenS0=Xand:
CP=XX/(l+rf)T
Therighthandsideoftheequationispositive,andweconcludethatC>P.
20-17
CFAPROBLEMS
1.
a.
Donieshouldchoosethelongstranglestrategy.Alongstrangleoptionstrategy
consistsofbuyingaputandacallwiththesameexpirationdateandthesame
underlyingasset,butdifferentexerciseprices.Inastranglestrategy,thecallhasan
exercisepriceabovethestockpriceandtheputhasanexercisepricebelowthe
stockprice.Aninvestorwhobuys(goeslong)astrangleexpectsthatthepriceof
theunderlyingasset(TRTMaterialsinthiscase)willeithermovesubstantially
belowtheexercisepriceontheputorabovetheexercisepriceonthecall.With
respecttoTRT,thelongstrangleinvestorbuysboththeputoptionandthecall
optionforatotalcostof$9.00,andwillexperienceaprofitifthestockprice
movesmorethan$9.00abovethecallexercisepriceormorethan$9.00belowthe
putexerciseprice.ThisstrategywouldenableDonie'sclienttoprofitfromalarge
moveinthestockprice,eitherupordown,inreactiontotheexpectedcourt
decision.
b.
i.Themaximumpossiblelosspershareis$9.00,whichisthetotalcostofthetwo
options($5.00+$4.00).
ii.Themaximumpossiblegainisunlimitedifthestockpricemovesoutsidethe
breakevenrangeofprices.
iii.Thebreakevenpricesare$46.00and$69.00.Theputwilljustcovercostsifthe
stockpricefinishes$9.00belowtheputexerciseprice
(i.e.,$55$9=$46),andthecallwilljustcovercostsifthestockpricefinishes
$9.00abovethecallexerciseprice(i.e.,$60+$9=$69).
2.
i.
Equityindexlinkednote:Unliketraditionaldebtsecuritiesthatpayascheduled
rateofcouponinterestonaperiodicbasisandtheparamountofprincipalat
maturity,theequityindexlinkednotetypicallypayslittleornocouponinterest;at
maturity,however,aunitholderreceivestheoriginalissuepriceplusa
supplementalredemptionamount,thevalueofwhichdependsonwheretheequity
indexsettledrelativetoapredeterminedinitiallevel.
ii.
Commoditylinkedbearbond:Unliketraditionaldebtsecuritiesthatpaya
scheduledrateofcouponinterestonaperiodicbasisandtheparamountof
principalatmaturity,thecommoditylinkedbearbondallowsaninvestorto
participateinadeclineinacommoditysprice.Inexchangeforalowerthan
marketcoupon,buyersofabeartranchereceivearedemptionvaluethatexceeds
thepurchasepriceifthecommoditypricehasdeclinedbythematuritydate.
20-18
3.
i.
Conversionvalueofaconvertiblebondisthevalueofthesecurityifitis
convertedimmediately.Thatis:
Conversionvalue=
marketpriceofthecommonstockconversionratio=
$4022=$880
ii.
Marketconversionpriceisthepricethataninvestoreffectivelypaysforthe
commonstockiftheconvertiblebondispurchased:
Marketconversionprice=
marketpriceoftheconvertiblebond/conversionratio=
$1,050/22=$47.73
4.
a.
i.Thecurrentmarketconversionpriceiscomputedasfollows:
Marketconversionprice=
marketpriceoftheconvertiblebond/conversionratio=
$980/25=$39.20
ii.TheexpectedoneyearreturnfortheYtelconvertiblebondis:
Expectedreturn=[(endofyearprice+coupon)/currentprice]1
=[($1,125+$40)/$980]1=0.1888=18.88%
iii.TheexpectedoneyearreturnfortheYtelcommonequityis:
Expectedreturn=[(endofyearprice+dividend)/currentprice]1
=($45/$35)1=0.2857=28.57%
b.
Thetwocomponentsofaconvertiblebondsvalueare:
thestraightbondvalue,whichistheconvertiblebondsvalueasabond,and;
theoptionvalue,whichisthevalueassociatedwiththepotentialconversion
intoequity.
(i.)InresponsetotheincreaseinYtelscommonequityprice,thestraightbond
valueshouldstaythesameandtheoptionvalueshouldincrease.
The increase in equity price does not affect the straight bond value component of
the Ytel convertible. The increase in equity price increases the option value
component significantly, because the call option becomes deep in the money
when the $51 per share equity price is compared to the convertibles conversion
price of: $1,000/25 = $40 per share.
20-19
(ii.)Inresponsetotheincreaseininterestrates,thestraightbondvalueshould
decreaseandtheoptionvalueshouldincrease.
Theincreaseininterestratesdecreasesthestraightbondvaluecomponent(bond
valuesdeclineasinterestratesincrease)oftheconvertiblebondandincreasesthe
valueoftheequitycalloptioncomponent(calloptionvaluesincreaseasinterest
ratesincrease).Thisincreasemaybesmallorevenunnoticeablewhencompared
tothechangeintheoptionvalueresultingfromtheincreaseintheequityprice.
5.
a.
(ii)
b.
(i)
[Profit=$40$25+$2.50$4.00]
20-20

Chapter 20 - Options Markets: Introduction

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