Berk Chapter20 Financial Optioins 111029180209 Phpapp01

Chapter 20
Financial Options
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Chapter Outline
20.1 Option Basics
20.2 Option Payoffs at Expiration
20.3 Put-Call Parity
20.4 Factors Affecting Option Prices
20.5 Exercising Options Early
20.6 Options and Corporate Finance
20-2
Learning Objectives
1.
Define the following terms: call option, put option,

exercise price, strike price, exercising the option,
expiration date, American option, European option, in-themoney, and out-of-the-money.
2.
Compute the value of a call or a put option at expiration.
3.
List the rights and obligations of the buyer of the option

and the seller of the option.
4.
Use put-call parity to solve for the call premium, the put
premium, the stock price, the strike price, or the dividend.
5.
Discuss the following factors that influence call and put

option values: stock price, strike price, and volatility.
20-3
Learning Objectives (cont'd)

6. Describe arbitrage bounds for option prices.
7. Explain why it is never optimal to exercise an
American call option early on a non-dividendpaying stock, and why it is sometimes optimal to
exercise an American put option early.
8. Explain the use of option modeling to value
equity.
9. Describe how corporate debt can be viewed as a
portfolio of riskless debt and a short position in a
put option.
20-4
20.1 Option Basics

Financial Option
A contract that gives its owner the right (but
not the obligation) to purchase or sell an asset
at a fixed price as some future date
Call Option
A financial option that gives its owner the right
to buy an asset
20-5
20.1 Option Basics (cont'd)

Put Option
A financial option that gives its owner the right
to sell an asset
Option Writer
The seller of an option contract
20-6
Understanding Option Contracts

Exercising an Option
When a holder of an option enforces the
agreement and buys or sells a share of stock at
the agreed-upon price
Strike Price (Exercise Price)

The price at which an option holder buys or
sells a share of stock when the option is
exercised
Expiration Date
The last date on which an option holder has the
right to exercise the option
20-7

(cont'd)
American Option
Options that allow their holders to exercise the
option on any date up to, and including, the
expiration date
European Option
Options that allow their holders to exercise the
option only on the expiration date
Note: The names American and European have
nothing to do with the location where the options are
traded.
20-8

(cont'd)
The option buyer (holder)
Holds the right to exercise the option and has a long
position in the contract
The option seller (writer)

Sells (or writes) the option and has a short position in
the contract
Because the long side has the option to exercise, the
short side has an obligation to fulfill the contract if it
is exercised.
The buyer pays the writer a premium.
20-9
Interpreting Stock Option

Quotations
Stock options are traded on organized
exchanges.
By convention, all traded options expire on
the Saturday following the third Friday of
the month.
Open Interest
The total number of contracts of a particular
option that have been written
20-10
Table 20.1 Option Quotes for

Amazon.com Stock
20-11

Quotations (cont'd)
At-the-money
Describes an option whose exercise price is
equal to the current stock price
In-the-money
Describes an option whose value if immediately
exercised would be positive
Out-of-the-money
Describes an option whose value if immediately
exercised would be negative
20-12

Quotations (cont'd)
Deep In-the-money
Describes an option that is in-the-money and
for which the strike price and the stock price
are very far apart
Deep Out-of-the-money
Describes an option that is out-ofthe-money
and for which the strike price and the stock
price are very far apart
20-13
Textbook Example 20.1
20-14
Textbook Example 20.1 (cont'd)
20-15
Alternative Example 20.1

Problem
It is December 30, 2009 and you have decided
to purchase 25 February put contracts on the
DJIA with an exercise price of $106.
20-16

Problem (continued)
How much money will this purchase cost
you?
Is this option in-the-money or out-of-themoney?
20-17

Solution
The ask price is $3.30 per contract.
The total cost is:
25 $3.30 100 = $8,250
Since the strike price exceeds the current price,

($105.49) the put option is in-the-money.
20-18
Options on Other Financial

Securities
Although the most commonly traded
options are on stocks, options on other
financial assets, like the S&P 100 index,
the S&P 500 index, the Dow Jones
Industrial index, and the NYSE index, are
also traded.
20-19
Options on Other Financial

Securities (cont'd)
Hedge
To reduce risk by holding contracts or securities
whose payoffs are negatively correlated with
some risk exposure
Speculate
When investors use contracts or securities to
place a bet on the direction in which they
believe the market is likely to move
20-20

Long Position in an Option Contract
The value of a call option at expiration is
C max (S K , 0)
Where S is the stock price at expiration, K is the
exercise price, C is the value of the call option, and
max is the maximum of the two quantities in the
parentheses
20-21
Figure 20.1 Payoff of a Call Option

with a Strike Price of $20 at Expiration
20-22

(cont'd)
Long Position in an Option Contract
The value of a put option at expiration is
P max (K S , 0)
Where S is the stock price at expiration, K is the
exercise price, P is the value of the put option, and
max is the maximum of the two quantities in the
parentheses
20-23
20-24
20-25

Problem
You own a put option on Dell stock with an
exercise price of $17.50 that expires today.
Plot the value of this option as a function of the
stock price.
20-26
Alternative Example 20.2 (cont'd)

Solution
Let S be the stock price and P be the value of
the put option. The value of the option is P=
max(12.50 - S,0)
20-27
Short Position in an Option Contract

An investor that sells an option has an
obligation.
This investor takes the opposite side of the
contract to the investor who bought the option.
Thus the sellers cash flows are the negative of
the buyers cash flows.
20-28
Figure 20.2 Short Position

in a Call Option at Expiration
20-29
20-30
20-31
Profits for Holding an Option to

Expiration
Although payouts on a long position in an
option contract are never negative, the
profit from purchasing an option and
holding it to expiration could be negative
because the payout at expiration might be
less than the initial cost of the option.
20-32
Figure 20.3 Profit from Holding

a Call Option to Expiration
20-33
20-34
20-35
Returns for Holding an Option

to Expiration
The maximum loss on a purchased call
option is 100% (when the option expires
worthless).
Out-of-the money call options are more
likely to expire worthless, but if the stock
goes up sufficiently it will also have a much
higher return than an in-the-money call
option.
Call options have more extreme returns
than the stock itself.
20-36
Returns for Holding an Option

to Expiration (cont'd)
The maximum loss on a purchased put
option is 100% (when the option expires
worthless).
Put options will have higher returns in
states with low stock prices.
Put options are generally not held as an
investment, but rather as insurance to
hedge other risk in a portfolio.
20-37
Figure 20.4 Option Returns from Purchasing

an Option and Holding It to Expiration
(a) The return on the expiration date from purchasing one of the August call options in Table 20.1 on July
8, 2009, and holding the position until the expiration date; (b) the same return for the August put options in
the table.
20-38
Combinations of Options
Straddle
A portfolio that is long a call option and a put
option on the same stock with the same
exercise date and strike price
This strategy may be used if investors expect the
stock to be very volatile and move up or down a large
amount, but do not necessarily have a view on which
direction the stock will move.
20-39
Figure 20.5 Payoff and Profit from a

Straddle
20-40
Combinations of Options (cont'd)

Strangle
A portfolio that is long a call option and a put
option on the same stock with the same
exercise date but the strike price on the call
exceeds the strike price on the put
20-41
20-42
20-43

Butterfly Spread
A portfolio that is long two call options with
differing strike prices, and short two call
options with a strike price equal to the average
strike price of the first two calls
While a straddle strategy makes money when the
stock and strike prices are far apart, a butterfly
spread makes money when the stock and strike
prices are close.
20-44
Figure 20.6 Butterfly Spread
20-45

Protective Put
A long position in a put held on a stock you
already own
Portfolio Insurance
A protective put written on a portfolio rather
than a single stock. When the put does not
itself trade, it is synthetically created by
constructing a replicating portfolio
20-46

Portfolio insurance can also be achieved by
purchasing a bond and a call option.
20-47
Figure 20.7 Portfolio Insurance
The plots show two different ways to insure against the possibility of the price of Amazon stock falling below $45.
The orange line in (a) indicates the value on the expiration date of a position that is long one share of Amazon
stock and one European put option with a strike of $45 (the blue dashed line is the payoff of the stock itself). The
orange line in (b) shows the value on the expiration date of a position that is long a zero-coupon riskfree bond with
a face value of $45 and a European call option on Amazon with a strike price of $45 (the green dashed line is the
bond payoff).
20-48
20.3 Put-Call Parity

Consider the two different ways to
construct portfolio insurance discussed
above.
Purchase the stock and a put
Purchase a bond and a call
Because both positions provide exactly the

same payoff, the Law of One Price requires
that they must have the same price.
20-49
20.3 Put-Call Parity (cont'd)

Therefore,
S P PV (K ) C
Where K is the strike price of the option (the
price you want to ensure that the stock will not
drop below), C is the call price, P is the put
price, and S is the stock price
20-50

Rearranging the terms gives an expression
for the price of a European call option for a
non-dividend-paying stock.
C P S PV (K )
This relationship between the value of the
stock, the bond, and call and put options is
known as put-call parity.
20-51
20-52
20-53

Problem
Assume:
You want to buy a one-year call option and put option
on Dell.
The strike price for each is $15.
The current price per share of Dell is $14.79.
The risk-free rate is 2.5%.
The price of each call is $2.23
Using put-call parity, what should be the

price of each put?
20-54

Solution
Put-Call Parity states:
S P PV (K ) C
$15
$14.79 P
$2.23
1.025
P $2.07
20-55

If the stock pays a dividend, put-call
parity becomes
C P S PV (K ) PV (Div)
20-56
20.4 Factors Affecting Option Prices

Strike Price and Stock Price
The value of a call option increases (decreases)
as the strike price decreases (increases), all
other things held constant.
The value of a put option increases (decreases)
as the strike price increases (decreases), all
20-57
20.4 Factors Affecting Option

Prices (cont'd)
Strike Price and Stock Price
The value of a call option increases (decreases)
as the stock price increases (decreases), all
The value of a put option increases (decreases)
as the stock price decreases (increases), all
20-58
Arbitrage Bounds on Option Prices

An American option cannot be worth less
than its European counterpart.
A put option cannot be worth more than its
strike price.
A call option cannot be worth more than
the stock itself.
20-59
Arbitrage Bounds on Option

Prices (cont'd)
Intrinsic Value
The amount by which an option is in-themoney, or zero if the option is out-of-themoney
An American option cannot be worth less than its
intrinsic value
20-60
Arbitrage Bounds on Option

Prices (cont'd)
Time Value
The difference between an options price and its
intrinsic value
An American option cannot have a negative time
value.
20-61
Option Prices and the Exercise Date

For American options, the longer the time
to the exercise date, the more valuable
the option
An American option with a later exercise date
cannot be worth less than an otherwise
identical American option with an earlier
exercise date.
However, a European option with a later exercise
date can be worth less than an otherwise identical
European option with an earlier exercise date
20-62
Option Prices and Volatility

The value of an option generally increases
with the volatility of the stock.
20-63
20-64
20-65
20.5 Exercising Options Early

Although an American option cannot be
worth less than its European counterpart,
they may have equal value.
20-66
Non-Dividend-Paying Stocks
C P S PV (K )
For a non-dividend paying stock, Put-Call
Parity can be written as
C S14 2 43K dis (K ) P

1 44 2 4 43
Intrinsic value
Time value
Where dis(K) is the amount of the discount

from face value of the zero-coupon bond K
20-67
(cont'd)
Because dis(K) and P must be positive
before the expiration date, a European call
always has a positive time value.
Since an American option is worth at least as
much as a European option, it must also have a
positive time value before expiration.
Thus, the price of any call option on a non-dividendpaying stock always exceeds its intrinsic value prior
to expiration.
20-68
(cont'd)
This implies that it is never optimal to
exercise a call option on a non-dividend
paying stock early.
You are always better off just selling the option.
Because it is never optimal to exercise an
American call on a non-dividend-paying stock
early, an American call on a non-dividend
paying stock has the same price as its
European counterpart.
20-69
(cont'd)
However, it may be optimal to exercise a
put option on a non-dividend paying stock
early.
P 1
K4 243S dis (K ) C
1 44 2 4 43
Intrinsic value
Time value
20-70
(cont'd)
When a put option is sufficiently deep inthe-money, dis(K) will be large relative to
the value of the call, and the time value of
a European put option will be negative. In
that case, the European put will sell for
less than its intrinsic value.
However, its American counterpart cannot sell
for less than its intrinsic value, which implies
that an American put option can be worth more
than an otherwise identical European option.
20-71
20-72
Table 20.2 Cisco Option Quotes
20-73
20-74
Dividend-Paying Stocks
The put-call parity relationship for a dividendpaying stock can be written as
C S14 2 43K dis (K ) P PV (Div)

1 4 4 4 44 2 4 4 4 4 43
Intrinsic value
Time value
If PV(Div) is large enough, the time value of a European

call option can be negative, implying that its price could
be less than its intrinsic value.
Because an American option can never be worth less
than its intrinsic value, the price of the American option
can exceed the price of a European option.
20-75
Dividend-Paying Stocks (cont'd)

With a dividend paying stock, it may be
optimal to exercise the American call
option early.
When a company pays a dividend, investors
expect the price of the stock to drop. When the
stock price falls, the owner of a call option
loses. Unlike the owner of the stock, the option
holder does not get the dividend as
compensation.
However, by exercising early and holding the stock,
the owner of the call option can capture the dividend.
20-76
20-77
Table 20.3 Option Quotes for GE on

December 21, 2005
20-78
20-79
Dividend-Paying Stocks (cont'd)

The put-call parity relationship for puts can
be written as
P 1
K4 243S C dis (K ) PV (Div)
1 4 4 4 44 2 4 4 4 4 43
Intrinsic value
Time value
As stated earlier, European options may trade

for less than their intrinsic value.
On the next slide, note that all the puts with a strike
price of $1400 or higher trade for less than their
exercise value.
20-80
Table 20.4 Two-Year Call and Put

Options on the S&P 500 Index
20-81
20.6 Options and Corporate Finance

Equity as a Call Option
A share of stock can be thought of as a call
option on the assets of the firm with a strike
price equal to the value of debt outstanding.
If the firms value does not exceed the value of debt
outstanding at the end of the period, the firm must
declare bankruptcy and the equity holders receive
nothing.
If the value exceeds the value of debt outstanding,
the equity holders get whatever is left once the debt
has been repaid.
20-82
Figure 20.8 Equity as a Call Option
20-83
Debt as an Option Portfolio

Debt holders can be viewed as owners of the firm
having sold a call option with a strike price equal
to the required debt payment.
If the value of the firm exceeds the required debt
payment, the call will be exercised; the debt holders will
therefore receive the strike price and give up the firm.
If the value of the firm does not exceed the required
debt payment, the call will be worthless, the firm will
declare bankruptcy, and the debt holders will be entitled
to the firms assets.
20-84
Debt as an Option Portfolio (cont'd)

Debt can also be viewed as a portfolio of riskless
debt and a short position in a put option on the
firms assets with a strike price equal to the
required debt payment.
When the firms assets are worth less than the required
debt payment, the owner of the put option will exercise
the option and receive the difference between the
required debt payment and the firms asset value. This
leaves the debt holder with just the assets of the firm.
If the firms value is greater than the required debt
payment, the debt holder only receives the required debt
payment.
20-85
Figure 20.9 Debt as an Option Portfolio
20-86
Credit Default Swaps

By rearranging Equation 20.9, we can eliminate a bonds
credit risk by buying the very same put option to protect or
insure it:
Risk-free debt = Risky debt + Put option on firm assets
This put option is called a credit default swap (or CDS).
In a credit default swap, the buyer pays a premium to the
seller and receives a payment from the seller to make up
for the loss if the bond defaults.
20-87
20-88
Figure 20.10 Google Call Option

Quotes and Implied Debt Yields
20-89
20-90
Agency Conflicts
In addition to pricing, the option
characterization of debt and equity
securities provides a new interpretation of
agency conflicts.
Because equity is like a call option, equity
holders will benefit from risky investments.
Debt is a short put option position, so debt
holders will be hurt by an increase in risk.
This can potentially lead to an
overinvestment problem.
20-91
Agency Conflicts
When the firm makes new investments
that increase the value of its assets, the
value of the put option will decline.
Since debt holders are short a put, the
value of the firms debt will increase, so
some fraction of the increase in the value
of assets will go to debt holders.
This reduces equity holders incentive to
invest, possibly leading to a debt overhang
(or underinvestment) problem.
20-92
Discussion of Data Case Key Topic

Instead of a straddle, suppose you recommend a
strangle for your uncle, where the call option
purchased is the one with the strike price right
above the current price, and the put option
purchased is the one with the strike price right
below the current price. Repeat parts a-f for that
option strategy. How does that strategy compare
with the straddle? Why? Option prices are at:
www.cboe.com
www.finra.org
20-93
Chapter Quiz
1. Does the holder of an option have to exercise it?
2. Why does an investor who writes (shorts) an
option have an obligation?
3. Explain how you can use put options to create
portfolio insurance. How can you create portfolio
insurance using call options?
4. If a put option trades at a higher price from the
value indicated by the put-call parity equation,
what action should you take?
5. What is the intrinsic value of an option?
20-94
Chapter Quiz
6. How does the volatility of a stock affect the value
of puts and calls written on the stock?
7. When might it be optimal to exercise an
American put option early?
8. When might it be optimal to exercise an
American call early?
9. Explain how equity can be viewed as a call option
on the firm.
10.Explain how debt can be viewed as an option
portfolio.
20-95

Berk Chapter20 Financial Optioins 111029180209 Phpapp01

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Berk Chapter20 Financial Optioins 111029180209 Phpapp01

Uploaded by

Copyright:

Available Formats

Chapter 20

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Define the following terms: call option, put option,

Compute the value of a call or a put option at expiration.

List the rights and obligations of the buyer of the option

Discuss the following factors that influence call and put

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives (cont'd)

20.1 Option Basics

Copyright 2011 Pearson Prentice Hall. All rights reserved.

20.1 Option Basics (cont'd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Understanding Option Contracts

Strike Price (Exercise Price)

Understanding Option Contracts

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Understanding Option Contracts

The option seller (writer)

The buyer pays the writer a premium.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Stock Option

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Table 20.1 Option Quotes for

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Stock Option

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Stock Option

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Textbook Example 20.1

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Textbook Example 20.1 (cont'd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 20.1

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 20.1

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 20.1

Since the strike price exceeds the current price,

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Options on Other Financial

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Options on Other Financial

Copyright 2011 Pearson Prentice Hall. All rights reserved.

20.2 Option Payoffs at Expiration

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Figure 20.1 Payoff of a Call Option

Copyright 2011 Pearson Prentice Hall. All rights reserved.

20.2 Option Payoffs at Expiration

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Textbook Example 20.2

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Textbook Example 20.2 (cont'd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 20.2

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Alternative Example 20.2 (cont'd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Short Position in an Option Contract

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Figure 20.2 Short Position

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Textbook Example 20.3

Copyright 2011 Pearson Prentice Hall. All rights reserved.