Ch 8: Financial options and applications in corp fin

Question 1

two fundamental approaches to valuing assets

Answer 1

1. discounted cash flow (DCF) approach- asset’s value is the PV of its cash flows
2. option pricing - basic principals: 1) many projects allow managers to make changes as market conditions change. understanding the basic financial options can help you manage the value of the options. 2) many companies use derivatives to manage risk and may derivatives are types of financial options so have to understand that before tackling deriv. 3) has insight into the optimal debt/equity choice 4) knowing about this will help you understand any employee stock option you receive.

Question 2

option

Answer 2

contract allowing the owner to buy/sell an asset at a certain price within a specific time period.

Question 3

call option

Answer 3

right to BUY a share of stock at a fixed price which is called the strike price/exercise price.

Question 4

put option

Answer 4

right to SELL a share of stock at a fixed trike price.

Question 5

american option

european option

Answer 5

1. the option can be exercised any time before the expiration. price will always be > or equal to its exercise value.
2. only exercised on the expiration date

Question 6

in the money
out of the money
exercise value

Answer 6

1. when the current stock price is > than the strike price. you get a payoff and profit.
2. payoff when you immediately exercise a call option

Question 7

time value

Answer 7

difference between option’s price and exercise value.

Question 8

exchanges for trading options

Answer 8

Chicago Board Options Exchange

• oldest and largest
• existing options can be traded in the secondary market
• new options can be “issued” by investors this is called writing an option

Question 9

covered call options

naked call options

Answer 9

1. an investor who writes call options against stock held in his portfolio is said to be selling this
2. call options sold without the stock to back them up

Question 10

options on stock indexes

Answer 10

• NYSE and S&P 100 Index. Index options allow one to bet on a rise/fall in the general market as well as on individual stocks.
• leverage in option trading makes it possible for someone to make a fortune overnight. investors with sizable portfolios can sell options against their stocks and earn the value of the option even if the stock’s price is constant.
• options can be used to create hedges that protect the value of an individual stock or portfolio.

Question 11

Long-term Equity AnticiPation Security (LEAPS)

Answer 11

• ## an option with an expiration date longer than typical. can have up to 3 years.

Question 12

Understand the Black-Scholes model, and its assumptions, and be able to calculate the value of a
call option using the model.

Answer 12

helped give rise to the rapid growth in options trading.
Assumptions:
1. the stock underlying the call option provides no dividends or other distributions during the life of the option.
2. no transaction costs for buying/selling either the stock or option
3. short-term, risk-free interest rate is known and constant during the life of the option
4. any purchaser of a security may borrow any fraction of the purchase price at the short term, risk free interest rate.
5. short selling is permitted and short seller will receive immediately the full cash proceeds of today’s price for a security sold short.
6. call option can be exercised only on expiration date
7. trading in all securities takes place continuously and stock price moves randomly

Question 13

Understand the five factors that influence the value of an option in the Black-Scholes model, and
the direction of their influence. In addition, understand which ones have the most influence on the option premium.

Answer 13

1. P, the stock’s price
2. t, the option’s time to expiration
3. X, the strike price
4. standard deviation of the underlying stock
5. Rrf, the risk free rate

• 1, 2, and 3 can be derived from sources. 5 is the yield on a treasury bill with a maturity equal to the option expiration date. 4 is from daily stock prices.

Question 14

relationship between call option prices and stock prices

Answer 14

call option prices increase when stock price increases bc the strike price is fixed so increase in stock price increases the change the option will be in the money at expiration.

call loose value as they become more out of the money.

the longer the call option has until expiration, the greater its value bc with a longer time - the stock price has a chance to increase above the strike price

Question 15

how does volatility (ST DEV) affect call options

Answer 15

as volatility increases (st. dev increases) the call option price increases.

the riskier the underlying security, the more valuable the option

Question 16

Risk free rate effect on option prices

Answer 16

small impact. it increases with the increase but option prices aren’t sensitive to interest rate changes.

Question 17

Put-Call Parity

Answer 17

• if the stock price is > the strike price at expiration –> the put is worth nothing so:
  payoff is = Pt (stock price at expiration date)
  call option is Pt - X
  cash is worth X
• if the stock price at expiration T is < X —> the payoff is X - Pt.
  so payoff is X - Pt

if 2 portfolios have identical payoffs, they must have identical values.

Question 18

Factors that affect Put option prices

Answer 18

exercise price, underlying stock price, time to expiration, stock’s st. dev, and Rrf rate affect.

• put prices are higher when stock price is lower and when exercise price is higher. (bc a put pays off when stock price declines below the exercise price)
• put prices are lower when Rrf rate is higher bc higher Rrf reduces PV of exercise price.
• put options are higher when st. dev is higher.
• effect of time to maturity is indeterminate.

Question 19

areas option pricing is used

Answer 19

real options analysis for project evaluation and strategic decisions
risk management
capital structure decisions
compensation plans

Question 20

Understand the relationship between the value of a share of stock, a call option on that stock, and

Answer 20

Option period: As the expiration date is lengthened, a call option’s value increases.
Longer time to expiration increases probability of very high stock price, which has big payoff.
Also increases the probability of a very low stock price, but payoff is zero for any price below the strike price.
Risk-free rate: Call option’s value tends to increase as rRF increases (reduces the PV of the exercise price).
Stock return variance: Option value increases with variance of the underlying stock.
Higher variance increases probability of very high stock price, which has big payoff.
Also increases the probability of a very low stock price, but payoff is zero for any price below the strike price.