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ActSc371_Lecture 24_Chapter 23 cont'd(Ross) -part 3

ActSc371_Lecture 24_Chapter 23 cont'd(Ross) -part 3 - ActSc...

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Lecture 23 Sections 23.7 – 23.8: Options and Corporate Finance – Basic Concepts Rules(Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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23.7 Valuing Options The last section concerned itself with the value of an option at expiry. This section considers the value of an option prior to the expiration date. A much more interesting question.
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The Factors Determining Call Option Values We’ve seen the value that options can have. The value of options comes from the spread between the exercise price and the stock price, and as the spread becomes larger the profit to be earned from options increases . There are several factors that affect the spread between the prices, and therefore the value of options. We consider five factors in this course.
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The Factors Determining Call Option Values 1. Stock price : The stock price affects the price spread directly. Remember that the holder of a call option wants the price to go up in order to buy the stock at a discounted price, so an increase in stock price will increase the value of a call option . In a similar way, the holder of a put option wants the price to go down in order to sell the stock at an inflated price, so an increase in stock price will decrease the value of a put option .
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The Factors Determining Call Option Values 2. Exercise price : Just as the stock price affects the price spread directly, so does the exercise price. The holder of a call option wants a lower exercise price in order to buy the stock at an even greater discounted price, so an increase in exercise price will decrease the value of a call option . In a similar way, the holder of a put option wants a higher exercise price in order to sell the stock at an even greater inflated price, so an increase in exercise price will increase the value of a put option .
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The Factors Determining Call Option Values 3. Variance (standard deviation) of stocks returns : The variance measures the error in estimation of a stock’s returns. In other words, it measures the probability that the returns will be very far from the mean. Therefore an increase in the variance, which necessarily means an increase in standard deviation, increases the probability that the stock price will change by greater amounts over time. This means that a larger spread is more probable, but since we don’t know in what direction the stock price would move, it will increase the value of both put and call options .
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The Factors Determining Call Option Values 3. Variance (standard deviation) of stocks returns : Example: Two stocks A and B, both of which are currently trading at $10. The price of stock A could go either up or down every month by 10%, while the price of stock B could go either up or down every month by 5%. Clearly, the variance of stock A is greater than stock B.
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