08 Fin 301 Options Ulearn - Options Options Options...

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1 Options 2 Options, Options Everywhere All risky investments have embedded options Managers have the option to: Cut back or abandon investments that go sour Expand investments that turn out well 3 Options and Volatility (i.e. Risk) The more volatile the investment, the more valuable the option Take advantage of favorable outcomes Walk away from unfavorable ones To understand the value of options in capital investment decisions, we must first examine standard financial options
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2 4 Financial Options Contracts between two parties: Writer or seller and Holder or buyer Seller transfers a set of rights to buyer Value of the contract determined by: Characteristics of underlying asset Nature of transferred rights 5 Types of Financial Options Call option: gives holder the right to buy underlying asset For a pre–specified price ( striking price ) By a pre–specified date ( expiration date ) Put option: gives holder the right to sell underlying asset For a pre–specified price ( striking price ) By a pre–specified date ( expiration date ) No obligation for the holder 6 Option Exercise Exercising the option = buying or selling the underlying asset at the exercise (striking) price Expiration date: last day option can be exercised (it is worthless afterwards) American option: can be exercised any time prior to expiration European option: can be exercised on expiration date only
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3 7 Payoff from Buying Call Option Buy call option today (at t = 0, stock price S 0 = $50) Expiration: in one year Exercise (striking) price : K = $60 Holder can BUT doesn’t have to buy stock for $60 in a year Stock Price Striking Price Payoff at expiration S 1 (t = 1) K S 1 –Kor0 $35 $60 $35 – $60 < 0 $0 $50 $60 $50 – $60 < 0 $0 $60 $60 $60 – $60 = $0 $65 $60 $65 – $60 = $5 $80 $60 $80 – $60 = $20 8 Payoff from Buying Call Option S 1 (Stock price in 1 year) S 1 – $60 $60 $80 $20 60 $ 0 60 $ 60 $ 1 1 1 S S S if if Payoff  0 , 60 $ max 1 S Payoff Payoff at expiration 9 Payoff from Buying Call Option S T (Stock price at time T) S T –K K  0 , max K S T Payoff K S K S K S T T T if if Payoff 0 S T > K Holder’s payoff is positive Non-negative payoff when S T < K !!!
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4 10 Payoff from Writing Call Option Write (sell) call option (at t = 0, stock price S 0 = $50) Expiration: in one year Exercise (striking) price : K = $60 Option holder’s gain = option writer’s loss (must sell at K!) – ($60 – $60) = $0 $60 – $60 = $0 $60 $60 $80 – $60 = $20 $65 – $60 = $5 $50 – $60 < 0 $0 $35 – $60 < 0
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This note was uploaded on 11/01/2011 for the course BUSINESS FIN301 taught by Professor Andrew during the Fall '10 term at University of Alberta.

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08 Fin 301 Options Ulearn - Options Options Options...

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