Chapter 23-24 Flashcards
What is the payoff to buyers and sellers of call and put options?
There are two basic types of options. A call option is the right to buy an asset at a specific exercise price on or before the exercise date. A put is the right to sell an asset at a specific exercise price on or before the exercise date. The payoff to a call is the value of the asset minus the exercise price if the difference is positive, and zero otherwise. The payoff to a put is the exercise price minus the value of the asset if the difference is positive, and zero otherwise. The payoff to the seller of an option is the negative of the payoff to the option buyer.
What are the determinants of option values?
The value of a call option depends on the following considerations:
∙ To exercise the call option, you must pay the exercise price. Other things equal, the less you are obliged to pay, the better. Therefore, the value of the option is higher when the exercise price is low relative to the stock price.
∙ Investors who buy the stock by way of a call option are buying on installment credit. They pay the purchase price of the option today, but they do not pay the exercise price until they exercise the option. The higher the rate of interest and the longer the time to expiration, the more this “free credit” is worth.
∙ No matter how far the stock price falls, the owner of the call cannot lose more than the price of the call. On the other hand, the more the stock price rises above the exercise price, the greater the profit on the call. Therefore, the option holder does not lose from increased variability if things go wrong, but gains if they go right. The value of the option increases with the variability of stock returns. Of course, the longer the time to the final exercise date, the more opportunity there is for the stock price to vary.
What options may be present in capital investment proposals?
The importance of building flexibility into investment projects (discussed in Chapter 10) can be reformulated in the language of options. For example, many capital investments provide the flexibility to expand capacity in the future if demand turns out to be buoyant.
They are, in effect, providing the firm with a call option on the extra capacity. Firms also think about alternative uses for their assets if things go wrong. The option to abandon a project is a put option; the put’s exercise price is the value of the project’s assets if shifted to an alternative use. The ability to expand or to abandon are both examples of real options.
What options may be provided in financial securities?
Many of the securities that firms issue contain an option. For example, a warrant is nothing but a long-term call option issued by the firm. Convertible bonds give the inves- tor the option to buy the firm’s stock in exchange for the value of the underlying bond. Unlike warrants and convertibles, which give an option to the investor, callable bonds give the option to the issuing firm. If interest rates decline and the value of the underlying bond rises, the firm can buy the bonds back at a specified exercise price.
Why do companies hedge to reduce risk?
Fluctuations in commodity prices, interest rates, or exchange rates make planning difficult and can throw companies badly off course. Financial managers, therefore, look for oppor- tunities to manage these risks, and a number of specialized instruments have been invented to help them. These are collectively known as derivative instruments. They include options, futures, forwards, and swaps.
How can futures and forward contracts be used to devise simple hedging strategies?
Futures contracts are agreements made today to buy or sell an asset in the future. The price is fixed today, but the final payment does not occur until the delivery date. Futures contracts are highly standardized and are traded on organized exchanges. Commodity futures allow firms to fix the future price that they pay for a wide range ofagricultural commodities, metals, and oil. Financial futures help firms to protect them- selves against unforeseen movements in interest rates, exchange rates, and stock prices.
Forward contracts are equivalent to tailor-made futures contracts. For example, firms often enter into forward agreements with a bank to buy or sell foreign exchange or to fix the interest rate on a loan to be made in the future.
How can companies use swaps to change the risk of securities that they have issued?
Swaps allow firms to exchange one series of future payments for another. For example, the firm might agree to make a series of regular payments in one currency in return for receiving a series of payments in another currency.
