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Unformatted text preview: 1 Financial Policy and Corporate Control  Cal ahan 1 Introduction to options Characteristics and value of financial options Financial Policy and Corporate Control  Cal ahan 2 Why learn about financial options in a corporate finance class? Understanding financial options is helpful for the following reasons (at least): 1. Options are present in corporate securities like warrants, convertible bonds, and executive stock options. 2. Options are used for risk management. 3. Projects include embedded options like the opportunity to expand or abandon a project. Financial Policy and Corporate Control  Cal ahan 3 Option basics The option contract – a contract in which the writer (seller) of the option grants the holder (buyer) of the option the right, but not the obligation , to buy from or sell to the writer an underlying asset at a fixed strike (exercise) price at or before an expiration (exercise, maturity) date. Call option Grants the holder the right to buy the underlying asset at a preset price The writer (seller) of the call is committed to sell the underlying asset at the fixed strike price if the holder exercises the option. Put option Grants the holder the right to sell the underlying asset at a preset price The writer (seller) of the put is committed to buy the underlying asset at the fixed strike price if the holder exercises the option. Options may be Exercised Traded in the market Allowed to expire 2 Financial Policy and Corporate Control  Cal ahan 4 Option basics (cont.) European vs American options European options can be exercised only on the exercise date. American options can be exercised on or before the exercise date. “Moneyness” of an option “In the Money”: an option that is profitable to exercise at the current price of the underlying asset. I.e., calls with strike prices below the current price and puts with strike prices above the current price. “Out of the Money”: an option that is unprofitable to exercise given the current price of the underlying. I.e., calls with exercise prices higher than the current price of the underlying and puts with strike prices below the current price of the underlying. “At the Money”: options for which the exercise price is roughly equal to current price of underlying. Financial Policy and Corporate Control  Cal ahan 5 Option basics – example GOOG options at: http://finance.yahoo.com/q/op?s=GOOG Financial Policy and Corporate Control  Cal ahan 6 Call option payoffs at expiration The value of an option at expiration is a function of the stock price and the exercise price. A call option gives you the right to buy a stock for $K (the strike price of the option) on date T (the expiration date of the option): If the stock is worth less than K on date T, i.e., S T < K, you will not exercise the option. Why buy the stock for $K when it is only worth a lesser amount, $S T ? Not exercising the option gives a payoff of 0. Not exercising the option gives a payoff of 0....
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 Fall '07
 Trimbath
 Options, Strike price, Callahan

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