Corporate Finance

1
Corporate Finance

• Dr. Ramakrishnan, USD
• A lecture on Options.
• Focus is NOT on valuation of Options, it is on
  Options and applications to CORPORATE FINANCE.
• ..

2
Options and Applications

• Terms.
• Concepts
• Types of Options
• Valuation (1997 Nobel Prize Winning Concept)
• Put-Call Parity Synthetic Contracts.
• Role of Options
• Applications.

3
Context

• Beyond barter transactions, we have a range of
  transactions that have evolved to meet specific
  needs.
• Types of Contracts (Essential Characteristics)
• Outright
• Cash or Spot
• Forwards
• Futures
• Contingent Contracts
• Options.

4
Concepts

• Options provide choices, and are of value.
• Contracts
• Outright, Swaps
• Contingent (value depends on some underlying
• CONTINGENT contracts
• Right but not the obligation ..

5
Types of Options

• Right to BUY (CALL)
• Right to SELL (PUT)
• For each type of options we have parties
• Buyer of the OPTION
• Seller of the OPTION
• Exchange to ensure performance

6
Option Terminology

• Call Option
• Right to buy an asset at a specified exercise
  price on or before the exercise date.

7
Option Terminology
Call Option Right to buy an asset at a specified
exercise price on or before the exercise date.

• Put Option
• Right to sell an asset at a specified exercise
  price on or before the exercise date.

8
Option Obligations
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Option Value

• The value of an option at expiration is a
  function of the stock price and the exercise
  price.

10
Option Value

• The value of an option at expiration is a
  function of the stock price and the exercise
  price.
• Example - Option values given a exercise price of
  85

11
Some Considerations

• Zero-sum game
• Buyer of OPTIONS always has the choice to
  exercise or let expire
• Seller/Writer of OPTIONS always has the
  obligations
• Performance is ensured by an Intermediary Agency
  for traded options

12
Valuation of Options - Calls

• Call Option Value (Price, Premium) a function of
• Underlying (Asset) Price
• Time to Maturity
• Riskiness of Underlying
• Risk Free Rate of Interest (Leverage Substitutes)
• Exercise Price (Only variable with Inverse
  Relation)

13
Payoff Diagrams - examples

• Payoff at Maturity
• Value of the Option relative to the underlying
  contract
• Payoffs for (buyers and sellers)
• CALLs,
• PUTs,
• Equity and
• Debt positions

14
Option Value
Call option value (graphic) given a 85 exercise
price.
Call option value
20
85 105
Share Price
15
Option Value
Put option value (graphic) given a 85 exercise
price.
Put option value
5
80 85
Share Price
16
Option Value
Call option payoff (to seller) given a 85
exercise price.
Call option payoff
85
Share Price
17
Option Value
Put option payoff (to seller) given a 85
exercise price.
Put option payoff
85
Share Price
18
Option Value

• Protective Put - Long stock and long put

Long Stock
Position Value
Share Price
19
Option Value

• Protective Put - Long stock and long put

Long Put
Position Value
Share Price
20
Option Value

• Protective Put - Long stock and long put

Protective Put
Position Value
Long Stock
Long Put
Share Price
21
Option Value

• Protective Put - Long stock and long put

Protective Put
Position Value
Share Price
22
Option Value

• Straddle - Long call and long put
• - Strategy for profiting from high volatility

Long call
Position Value
Share Price
23
Option Value

• Straddle - Long call and long put
• - Strategy for profiting from high volatility

Long put
Position Value
Share Price
24
Option Value

• Straddle - Long call and long put
• - Strategy for profiting from high volatility

Straddle
Position Value
Share Price
25
Option Value

• Straddle - Long call and long put
• - Strategy for profiting from high volatility

Straddle
Position Value
Share Price
26
Option Value
Stock Price
Upper Limit
27
Option Value
Stock Price
Upper Limit
Lower Limit
(Stock price - exercise price) or 0 whichever
is higher
28
Black-Scholes Option Pricing Model
OC PsN(d1) - SN(d2)e-rt
OC- Call Option Price Ps - Stock Price N(d1) -
Cumulative normal density function of (d1) S -
Strike or Exercise price N(d2) - Cumulative
normal density function of (d2) r - discount rate
(90 day comm paper rate or risk free rate) t -
time to maturity of option (as of year) v -
volatility - annualized standard deviation of
daily returns
29
Black-Scholes Option Pricing Model
Ps S
v2 2
ln ( r ) t
(d1)
v t
N(d1)
32 34 36 38 40
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Cumulative Normal Density Function
Ps S
v2 2
ln ( r ) t
(d1)
v t
(d2) d1 -
v t
31
Financial Engineering

• Basic Building Blocks of Finance
• Equity (Ownership Positions) ex Stocks
• Debt (Creditor Positions) ex Bonds
• Call Option
• Put Option
• Combining Payoffs (ex.)
• S P
• B C
• Put Call Parity Relationships.

32
Put-Call Parity Relationship

• Arbitrage provides the logic for why this works
  this way.
• If two contract combinations provide identical
  payoffs in all states of the world, they should
  be priced the same - else Arbitrage possibilities
  exist

33
Applications

• Speculation
• Financial Engineering - change the
  risk-exposure i.e. payoff pattern
• Hedging, Limiting Loss without giving up upside
• Income generation (ex. Writing puts) etc.

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Applications in Corporate Finance (1 of 4)

• Framework has broad applicability
• Ex. Warrants think long term call options,
  issued by firm
• Uses
• Sweeteners for Bonds / Preferred stock issue
• Firms sometimes think of them as deferred sale of
  equity. LOGIC? Think through this..
• THINK we win either way, if the convertible
  bond is converted into equity, we sell stock for
  higher than current price else if not converted,
  we got cheaper debt

35
Applications in Corporate Finance (contd. 2 of 4)

• Framework has broad applicability
• ex. Convertible Bonds decompose into Straight
  Bond Plus Call Option
• Compare payoffs relative to that of straight bond
  (varies with interest rates stock prices.
• Pricing relative to straight bonds?

36
Applications in Corporate Finance (contd. 3 of 4)

• Framework has broad applicability
• ex. Equity as call options on firms asset
• Implications for owners of stock / managers ?
  Behavior?
• ..
• THINK What does the value of Call Options depend
  on?
• Therefore, how can managers maximize the value of
  the firms stock?

37
Applications in Corporate Finance (contd. 4 of 4)

• Framework has broad applicability
• ex. Underwriting Commitments
• What type of contracts are these?
• How can one value them?
• ex. Managerial (Employee) (ESPOs) Incentives
• ex. Reduce Agency Problems by aligning interests