Chapter_14_Presentation - 14 Options and Corporate Finance...

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14 Options and Corporate Finance
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14-2 Definition Definition Options are a right - not an obligation to receive or deliver an underlying security at a specified price on or before a specified date . Options are a form of derivative security: their payoff depends ( derives) from the payoff of another security.
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14-3 Option Terminology Option Terminology Call=C. Gives holder the right to buy stock. Put=P. Gives holder the right to sell stock. Strike or Exercise price=E (or X) Expiration date Option premium/value (time 0); C 0 or P 0 Option value at expiration; C 1 or P 1 Option writer (seller) American Option (can be exercised anytime at or before maturity date) European Option (can ONLY be exercised on maturity date)
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14-4 Use of Options Use of Options Speculation o Bet on the direction of stock movement o Amplify returns due to small investments o Expose to risks of losing all investments Hedging o Secure a target return regardless of stock movement o Limited upside potential o Limited downside risk
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14-5 Option Payoffs – Calls Option Payoffs – Calls The value of the call at expiration is the intrinsic value Max(0, S-E) If S<E, then the payoff is 0 If S>E, then the payoff is S – E Assume that the exercise price is $30 Call Option Payoff Diagram 0 5 10 15 20 25 0 10 20 30 40 50 60 Stock Price Call Valuee
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14-6 Buying calls to speculate Buying calls to speculate In the previous example, the exercise price is $30. Let’s say C 0 =$3 and S 0 =$30. Compare the results of buying 10 calls versus buying 1 share of stock (invest $30 either way). If, say, S 1 =$50, I generate a 66% return on the stock, but I generate a 566% return on the options. If S 1 =$20, I lose 33.3% on the stock; I lose 100% on the options (they expire worthless because S 1 <E at expiration).
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14-7 Option Payoffs - Puts Option Payoffs - Puts The value of a put at expiration is the intrinsic value Max(0, E-S) If S<E, then the payoff is E-S If S>E, then the payoff is 0 Assume that the exercise price is $30 Payoff Diagram for Put Options 0 5 10 15 20 25 30 35 0 10 20 30 40 50 60 Stock Price Option Value
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14-8 Buying puts to speculate Buying puts to speculate In the previous example, the exercise price is $30. Let’s say P 0 =$2 and S 0 =$30. Compare the results of buying 15 puts versus buying 1 share of stock (invest $30 either way). If, say, S 1 =$50, I generate a 66% return on the stock; I lose 100% on the options (they expire worthless because S 1 >E at expiration). If S 1 =$20, I lose 33.3% on the stock; I gain 400% on the put options.
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14-9 Buying puts to hedge Buying puts to hedge Now let’s assume P 0 =$2 and S 0 =$30. Compare the results of owning a share of stock versus owning a share of stock AND a put option. (Invest $30 versus $32)
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Chapter_14_Presentation - 14 Options and Corporate Finance...

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