22-0

CHAPTER
22
Options and Corporate
Finance: Basic Concepts

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22-1

Chapter Outline
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Reading The Wall Street Journal
22.6 Combinations of Options
22.7 Valuing Options
22.8 An Option-Pricing Formula
22.9 Stocks and Bonds as Options
22.10 Capital-Structure Policy and Options
22.11 Mergers and Options
22.12 Investment in Real Projects and Options
22.13 Summary and Conclusions

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22-2

22.1 Options
Many corporate securities are similar to the stock
options that are traded on organized exchanges.
Almost every issue of corporate stocks and bonds
has option features.
In addition, capital structure and capital
budgeting decisions can be viewed in terms of
options.

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22-3

22.1 Options Contracts:

Preliminaries
An option gives the holder the right, but not the obligation, to buy
or sell a given quantity of an asset on (or perhaps before) a given
date, at prices agreed upon today.
Calls versus Puts
Call options gives the holder the right, but not the obligation, to buy
a given quantity of some asset at some time in the future, at prices
agreed upon today. When exercising a call option, you “call in” the
asset.
Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you “put” the asset to someone.

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22-4

22.1 Options Contracts: Preliminaries

Exercising the Option
The act of buying or selling the underlying asset through the option contract.
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
The maturity date of the option is referred to as the expiration date, or the expiry.
European versus American options
European options can be exercised only at expiry.
American options can be exercised at any time up to expiry.

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22-5

Options Contracts: Preliminaries

In-the-Money
The exercise price is less than the spot price of the underlying
asset.
At-the-Money
The exercise price is equal to the spot price of the underlying
asset.
Out-of-the-Money
The exercise price is more than the spot price of the
underlying asset.

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22-6

Options Contracts: Preliminaries

Intrinsic Value
The difference between the exercise price of the
option and the spot price of the underlying asset.
Speculative Value
The difference between the option premium and the
intrinsic value of the option.
Option Intrinsic + Speculative
=
Premium Value Value
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22-7

22.2 Call Options

Call options gives the holder the right, but
not the obligation, to buy a given quantity
of some asset on or before some time in the
future, at prices agreed upon today.
When exercising a call option, you “call in”
the asset.

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22-8

Basic Call Option Pricing Relationships

at Expiry
At expiry, an American call option is worth the same as a
European option with the same characteristics.
If the call is in-the-money, it is worth ST – E.
If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the call option at expiry
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22-9

Call Option Payoffs

60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50

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22-10

Call Option Payoffs

60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50

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22-11

Call Option Profits

60
Option payoffs ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50;

–40 Sell a call
option premium = $10
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22-12

22.3 Put Options

Put options gives the holder the right, but
not the obligation, to sell a given quantity of
an asset on or before some time in the
future, at prices agreed upon today.
When exercising a put, you “put” the asset
to someone.

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22-13

Basic Put Option Pricing Relationships

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]
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22-14

Put Option Payoffs

60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

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22-15

Put Option Payoffs

Option payoffs ($)

40

20

Sell a put
0
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

–50

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22-16

Put Option Profits

60
Option payoffs ($)

40

20
Sell a put
10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10

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22-17

22.4 Selling Options

The seller (or writer) of an option has an obligation.
The purchaser of an option has an option.
Option payoffs ($)

40 Buy a call

Sell a call
10 Sell a put

Stock price ($)

Buy a call 40 50 60 100
–10 Buy a put

Exercise price = $50;

–40 option premium = $10 Sell a call
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22-18

22.5 Reading The Wall

Street Journal
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½

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22-19

22.5 Reading The Wall Street Journal

This option has a strike price of $135;

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
a recent price for the stock is $138.25
July is the expiration month
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22-20

22.5 Reading The Wall Street Journal

This makes a call option with this exercise price in-the-
money by $3.25 = $138¼ – $135.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½

Puts with this exercise price are out-of-the-money.

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22-21

22.5 Reading The Wall Street Journal

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½

On this day, 2,365 call options with this

exercise price were traded.
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22-22

22.5 Reading The Wall Street Journal

The CALL option with a strike price
of $135 is trading for $4.75.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying
this option would cost $475 plus commissions.
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22-23

22.5 Reading The Wall Street Journal

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
On this day, 2,431 put options with this
exercise price were traded.
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22-24

22.5 Reading The Wall Street Journal

The PUT option with a strike price of $135 is
trading for $.8125.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
Since the option is on 100 shares of stock, buying
this option would cost $81.25 plus commissions.
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22-25

22.6 Combinations of Options

Puts and calls can serve as the building
blocks for more complex option contracts.
If you understand this, you can become a
financial engineer, tailoring the risk-return
profile to meet your client’s needs.

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22-26

Protective Put Strategy: Buy a Put and Buy

the Underlying Stock: Payoffs at Expiry
Value at Protective Put payoffs
expiry

$50

Buy the
stock Buy a put with an exercise
price of $50

$0
Value of
$50 stock at
expiry
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22-27

Protective Put Strategy Profits

Value at Buy the stock at $40
expiry
$40 Protective Put
strategy has
downside protection
and upside potential

$0

-$10
$40 $50
Buy a put with exercise price of $50
for $10 Value of
stock at
-$40 expiry
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22-28

Covered Call Strategy

Value at Buy the stock at $40
expiry

$10 Covered Call strategy

$0
Value of stock at expiry

$40 $50
Sell a call with exercise price
of $50 for $10
-$30
-$40

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22-29

Long Straddle: Buy a Call and a Put

Option payoffs ($)

40 Buy a call with exercise

price of $50 for $10
30

Stock price ($)

30 40 60 70
Buy a put with exercise
price of $50 for $10
–20

$50
A Long Straddle only makes money if the stock price moves
$20 away from $50.
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22-30

Long Straddle: Buy a Call and a Put

This Short Straddle only loses money if the stock
price moves $20 away from $50.
Option payoffs ($)

20
Sell a put with exercise price of
$50 for $10
Stock price ($)
30 40 60 70
$50

–30
Sell a call with an
–40 exercise price of $50 for $10
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22-31

Put-Call Parity: p0 + S0 = c0 + E/(1+ r)T

E Portfolio payoff
Portfolio value today = c0 +
(1+ r)T
Option payoffs ($)

Call

25 bond

25 Stock price ($)

Consider the payoffs from holding a portfolio
consisting of a call with a strike price of $25 and a
bond with a future value of $25.
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22-32

Put-Call Parity: p0 + S0 = c0 + E/(1+ r)T

Portfolio payoff
Portfolio value today = p0 + S0
Option payoffs ($)

25

Stock price ($)

25
Consider the payoffs from holding a portfolio
consisting of a share of stock and a put with a $25
strike.
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22-33

Put-Call Parity: p0 + S0 = c0 + E/(1+ r)T

Portfolio value today
Option payoffs ($)

Option payoffs ($)

Portfolio value today
E = p0 + S0
= c0 +
(1+ r)T

25 25

25 Stock price ($) Stock price ($)

25

Since these portfolios have identical payoffs, they must have the same
value today: hence
Put-Call Parity: c0 + E/(1+r)T = p0 + S0
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22-34

22.7 Valuing Options

The last section
concerned itself with
the value of an option
at expiry.
This section considers
the value of an option
prior to the expiration
date.
A much more
interesting question.

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22-35

Option Value Determinants

Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate + –
4. Volatility in the stock price + +
5. Expiration date + +

The value of a call option C0 must fall within

max (S0 – E, 0) < C0 < S0.
The precise position will depend on these factors.
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22-36

Market Value, Time Value and Intrinsic Value

for an American Call

Profit ST
Option payoffs ($)

Call

25
Market Value
Time value
Intrinsic value

ST
E
Out-of-the-money In-the-money
loss The value of a call option C0 must fall within max (S0 – E, 0) < C0 < S0.

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22-37

22.8 An Option-Pricing Formula

We will start with a Then we will
binomial option graduate to the
pricing formula to normal
build our intuition. approximation to
the binomial for
some real-world
option valuation.

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22-38

Binomial Option Pricing Model

Suppose a stock is worth $25 today and in one period will either be
worth 15% more or 15% less. S0= $25 today and in one year S1is
either $28.75 or $21.25. The risk-free rate is 5%. What is the
value of an at-the-money call option?

S0 S1
$28.75 = $25×(1.15)

$25

$21.25 = $25×(1 –.15)

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Binomial Option Pricing Model

1. A call option on this stock with exercise price of $25 will have
the following payoffs.
2. We can replicate the payoffs of the call option. With a levered
position in the stock.

S0 S1 C1
$28.75 $3.75

$25

$21.25 $0
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22-40

Binomial Option Pricing Model

Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either
$7.50 or $0.
The levered equity portfolio has twice the option’s payoff so the
portfolio is worth twice the call option value.

S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
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22-41

Binomial Option Pricing Model

The value today of the levered equity portfolio is
today’s value of one share less the present value
of a $21.25 debt: $21.25
$25 
(1  rf )
S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
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22-42

Binomial Option Pricing Model

We can value the call option today
1  $21.25 
as half of the value of the C0  $25 
levered equity portfolio: 2  (1  rf ) 

S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
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22-43

The Binomial Option Pricing Model

If the interest rate is 5%, the call is worth:
1 $21.25  1
C0   $25    $25  20.24  $2.38
2 (1.05)  2

C0 S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$2.38 $25

$21.25 – $21.25 = $0 $0
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22-44

Binomial Option Pricing Model

The most important lesson (so far) from the
binomial option pricing model is:
the replicating portfolio intuition.

Many derivative securities can be valued by

valuing portfolios of primitive securities
when those portfolios have the same
payoffs as the derivative securities.
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22-45

Delta and the Hedge Ratio

This practice of the construction of a
riskless hedge is called delta hedging.
The delta of a call option is positive.
Recall from the example:
Swing of call $3.75  0 $3.75 1
D   
Swing of stock $28.75  $21.25 $7.5 2

The delta of a put option is negative.

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Delta
Determining the Amount of Borrowing:
1 $21.25  1
C0   $25    $25  $20.24  $2.38
2 (1.05)  2

Value of a call = Stock price × Delta – Amount

borrowed

$2.38 = $25 × ½ – Amount borrowed

Amount borrowed = $10.12
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22-47

The Risk-Neutral Approach to Valuation

S(U), V(U)
q

S(0), V(0)

1- q
S(D), V(D)
We could value V(0) as the value of the replicating
portfolio. An equivalent method is risk-neutral
valuation    
q V (U ) (1 q) V ( D)
V (0) 
(1  rf )
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The Risk-Neutral Approach to Valuation

S(U), V(U)
q
q is the risk-neutral
S(0), V(0) probability of an
“up” move.
1- q
S(0) is the value of the
S(D), V(D)
underlying asset today.
S(U) and S(D) are the values of the asset in
the next period following an up move and a
down move, respectively.
V(U) and V(D) are the values of the asset in the next period
following an up move and a down move, respectively.
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The Risk-Neutral Approach to Valuation

S(U), V(U)
q
q V (U )  (1  q) V ( D)
V (0) 
S(0), V(0)
(1  rf )
1- q
S(D), V(D)

The key to finding q is to note that it is already impounded into an

observable security price: the value of S(0):
q  S (U )  (1  q)  S ( D)
S (0) 
(1  rf )
(1  rf )  S (0)  S ( D)
A minor bit of algebra yields: q 
S (U )  S ( D)
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22-50

Example of the Risk-Neutral Valuation of a Call:

Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. The risk-free rate is
5%. What is the value of an at-the-money call option?
The binomial tree would look like this:
$28.75  $25 (1.15)

q $28.75,C(D)

$25,C(0) $21.25  $25 (1 .15)

1- q
$21.25,C(D)
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Example of the Risk-Neutral Valuation of a Call:

The next step would be to compute the risk

neutral probabilities
(1  rf )  S (0)  S ( D)
q
S (U )  S ( D)
(1.05) $25 $21.25 $5
q  2 3
$28.75 $21.25 $7.50

2/3 $28.75,C(D)

$25,C(0)

1/3
$21.25,C(D)
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22-52

Example of the Risk-Neutral Valuation of a Call:

After that, find the value of the call in the up

state and down state.
C (U )  $28.75  $25

2/3 $28.75, $3.75

$25,C(0) C ( D)  max[$25  $28.75,0]

1/3
$21.25, $0

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22-53

Example of the Risk-Neutral Valuation of a Call:

Finally, find the value of the call at time 0:

q C (U )  (1  q) C ( D)
C (0) 
(1  rf )

2 3 $3.75  (1 3) $0
C (0) 
(1.05)

$2.50 $28.75,$3.75
C (0)   $2.38 2/3
(1.05)
$25,$2.38
$25,C(0)

1/3
$21.25, $0
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22-54

Risk-Neutral Valuation
and the Replicating Portfolio
This risk-neutral result is consistent with
valuing the call using a replicating portfolio.

2 3  $3.75  (1 3)  $0 $2.50
C0    $2.38
(1.05) 1.05

1 $21.25  1
C0   $25    $25  20.24  $2.38
2 (1.05)  2

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22-55

The Black-Scholes Model

The Black-Scholes Model is
rT
Where C0 S N(d1 ) Ee  N(d2 )
  
C0 = the value of a European option at time t = 0
r = the risk-free interest rate.
σ2 N(d) = Probability that a
ln(S / E )  ( r  )T standardized, normally
d1  2
s T distributed, random
variable will be less than
d2  d1  s T or equal to d.
The Black-Scholes Model allows us to value options in the
real world just as we have done in the 2-state world.
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22-56

The Black-Scholes Model

Find the value of a six-month call option on the Microsoft
with an exercise price of $150
The current value of a share of Microsoft is $160
The interest rate available in the U.S. is r = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the option
is $10—our answer must be at least that amount.

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22-57

The Black-Scholes Model

Let’s try our hand at using the model. If you have a
calculator handy, follow along.
First calculate d1 and d2
ln(S / E )  (r .5σ 2 )T
d1 
s T
ln(160 / 150)  (.05 .5(0.30)2 ).5
d1   0. 5282
0.30 .5
Then,
d2  d1  s T  0.52815  0.30 .5  0.31602
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22-58

The Black-Scholes Model

rT
C0 S N(d1 ) Ee  N(d2 )
  

d1  0.5282 N(d1) = N(0.52815) = 0.7013

d2  0.31602 N(d2) = N(0.31602) = 0.62401
.05 .5
  
C0 $160 0. 7013 150e 0. 62401
C0  $20.92

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22-60

22.9 Stocks and Bonds as Options

Levered Equity is a Call Option.
The underlying asset comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are
greater in value than the debt, the shareholders have an
in-the-money call, they will pay the bondholders and
“call in” the assets of the firm.
If at the maturity of the debt the shareholders have an
out-of-the-money call, they will not pay the bondholders
(i.e. the shareholders will declare bankruptcy) and let the
call expire.

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22-61

22.9 Stocks and Bonds as Options

Levered Equity is a Put Option.
The underlying asset comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are
less in value than the debt, shareholders have an in-the-
money put.
They will put the firm to the bondholders.
If at the maturity of the debt the shareholders have an
out-of-the-money put, they will not exercise the option
(i.e. NOT declare bankruptcy) and let the put expire.

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22-62

22.9 Stocks and Bonds as Options

It all comes down to put-call parity.
E
c0 = S0 + p0 –
(1+ r)T
Value of a Value of a Value of a
Value of
call on the = the firm + put on the – risk-free
firm firm bond

Stockholder’s Stockholder’s
position in terms position in terms
of call options of put options
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22-63

22.10 Capital-Structure Policy

and Options
Recall some of the agency costs of debt:
they can all be seen in terms of options.
For example, recall the incentive
shareholders in a levered firm have to take
large risks.

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22-64

Balance Sheet for a Company

in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0

Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

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22-65

Selfish Strategy 1: Take Large Risks

The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0

Cost of investment is $200 (all the firm’s cash)

Required return is 50%

Expected CF from the Gamble = $1000 × 0.10 + $0 = $100

$100
NPV = –$200 +
(1.10)
NPV = –$133
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22-66

Selfish Stockholders Accept Negative NPV

Project with Large Risks
Expected CF from the Gamble
To Bondholders = $300 × 0.10 + $0 = $30
To Stockholders = ($1000 – $300) × 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
$30
PV of Bonds With the Gamble: $20 =
(1.50)
$70
PV of Stocks With the Gamble: $47 =
(1.50)
The stocks are worth more with the high risk project because the call
option that the shareholders of the levered firm hold is worth more when
the volatility of the firm is increased.
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22-67

22.11 Mergers and Options

This is an area rich with optionality, both in the
structuring of the deals and in their execution.
In the first half of 2000, General Mills was
attempting to acquire the Pillsbury division of
Diageo PLC.
The structure of the deal was Diageo’s
stockholders received 141 million shares of
General Mills stock (then valued at $42.55) plus
contingent value rights of $4.55 per share.
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22-68

22.11 Mergers and Options

Cash The contingent value rights paid
payment to the difference between $42.55 and
newly General Mills’ stock price in one
issued
shares
year up to a maximum of $4.55.

$4.55
$0
Value of General
$38 $42.55
Mills in 1 year

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22-69

22.11 Mergers and Options

The contingent value plan can be viewed in
terms of puts:
Each newly issued share of General Mills
given to Diageo’s shareholders came with a
put option with an exercise price of $42.55.
But the shareholders of Diageo sold a put with
an exercise price of $38

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22-70

22.11 Mergers and Options

Cash payment to newly issued shares
Own a put
Strike $42.55
$42.55

$42.55
– $38.00
$4.55
$0
Value of General
$38 $42.55
Mills in 1 year

Sell a put
–$38 Strike $38
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22-71

22.11 Mergers and Options

Value of
General Value of a share
Mills in 1 Value of a share
year plus cash
payment

$42.55

$4.55
$0
Value of General
$38 $42.55 Mills in 1 year
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22-72

22.12 Investment in Real Projects & Options

Classic NPV calculations typically ignore

the flexibility that real-world firms typically
have.
The next chapter will take up this point.

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22-73

22.13 Summary and Conclusions

The most familiar options are puts and calls.
Put options give the holder the right to sell stock at a
set price for a given amount of time.
Call options give the holder the right to buy stock at a
set price for a given amount of time.
Put-Call parity

c0– E
T = S0 + p0
(1+ r)
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22-74

22.13 Summary and Conclusions

The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
• Much of corporate financial theory can be presented in
terms of options.
1. Common stock in a levered firm can be viewed as a call option on the
assets of the firm.
2. Real projects often have hidden option that enhance value.

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