22_Oheads

22_Oheads - Lecture Notes 22 Options and Corporate Finance...

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1 Lecture Notes 22 Options and Corporate Finance • We first discuss how options provide a means for risk averse in- vestors to flexibly manage risks. • We then talk about valuing options and end the notes by applying options theory to a number of issues. Some options terminology • An option can be either a call option or a put option. Either type of option is characterized by: i. its underlying instrument ii. a contract amount iii. a strike or exercise price iv. an expiration date. • Both put and call options can be either American options or Eu- ropean options. • An American call option gives the purchaser the right ( but not
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2 the obligation) to pur c hase the contracted amount of the under- lying instrument at the strike price on or before the expiration date. • An American put option gives the purchaser the right ( but not the obligation ) to sell the contracted amount of the underlying in- strument at the strike price on or before the expiration date. • European options are allowed to be exercised only on the expi- ration date. • A call option is in the money if the value of the underlying instru- ment exceeds the strike price. A put option is in the money if the value of the underlying instrument is below the strike price. • Investors can simply walk away from options that are out of the money . They are not obliged to exercise them. • The seller of an option has an obligation to deliver the underly- ing instrument at the strike price if the option is exercised. • The intrinsic value of an in the money option is the difference between the underlying instrument value and the strike price.
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3 • An American option must be worth at least as much as the intrin- sic value, if the latter is positive, since the option can always be exercised early and the intrinsic value realized. • Since an option is useful as insurance against price movements, however, it generally will be worth more than the intrinsic value. • Hence, even though an American can be exercised early it usu- ally is not profitable to do so. • Thus, the distinction between American and European options is less significant than it might first appear. • The difference between the current option premium and the in- trinsic value is called the speculative value . Option v alue at maturity • At expiry, an American option is worth the same as a European option with the same characteristics. • Consider a call option on a stock with maturity date T and strike (or exercise) price K. Let the stock price at T be p T .
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4 • The call is worth p T K if it is in the money, and is worthless otherwise. Hence, the value of the call option at expiry is • Figure 1 illustrates the payoff at T from buying a call option. • If the call option is sold it will cost the seller (or writer ) p T K if it is in the money. Even if the seller owns the underlying stock, the opportunity cost of delivering on the option is p T K since the stock could have been sold for p T if the option did not exist.
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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22_Oheads - Lecture Notes 22 Options and Corporate Finance...

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