Lecture 5 - _a_ Options and Corporate Liabilities AND _b_ RNV

Lecture 5 - _a_ Options and Corporate Liabilities AND _b_ RNV

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UGBA103 Summer2008 1 BA 103 Summer 2008 Lecture 5
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UGBA103 Summer2008 2 Part 1: Options and Corporate Liabilities
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UGBA103 Summer2008 3 Options: Calls and Puts A Call option gives its holder the right to buy a certain asset (the underlying ) on or before a certain date ( maturity or expiration date) for a fixed price (the strike or exercise price) A Put option gives its holder the right to sell the underlying on or before the maturity date for the strike price If an option can be exercised only on the maturity date, it’s known as a European Option; if it can be exercised on as well as before the maturity date, it’s known as an American Option Thus, we have four kinds of options: an American Call ( AC ), a European Call ( EC ), an American Put ( AP ), and a European Put ( EP )
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UGBA103 Summer2008 4 Calls and Puts ( 2 ) In order that the holder (buyer) of the contract may have the option , the other party, known as the writer (seller), must assume an obligation . The holder compensates the writer for assuming the obligation by paying her a premium (option price). You are said to write an option when you sell to open a contract.
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UGBA103 Summer2008 5 Notation We shall denote the price of the underlying as A , the strike as K , the price of the European Call as EC , and that of European Put as EP . Unsubscripted prices pertain to current time. T stands for the term to maturity (TTM). Prices subscripted with T are terminal prices. Thus, Ã T is the price of the underlying on maturity date, C T is the terminal price of (both European and American) Call, and P T is that of Put at time T .
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UGBA103 Summer2008 6 Payoff of Options at Expiration Suppose you own a call that entitles you to buy MSFT at $20. It expires today when à T (or P MSFT )= $27 The value of this right is $7 because it entitles you to a profit of $7 (you buy MSFT @ $20 when you exercise the call, and sell it in the market @ $27).
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UGBA103 Summer2008 7 Terminal Payoff of Options ( 2 ) On the other hand, suppose à T = $17. Then, the holder of the call will not exercise the right to buy. The value of this right in the event that à T <$20(= K ) is zero.
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UGBA103 Summer2008 8 Terminal Payoff of Options ( 3 ) It is obvious that the terminal payoff of the call depends only on whether à T is above or below K : if à T < K , C T =0, but if à T >K, C T = à T K. This can be written concisely as C T =MAX( à T K , 0) By a similar logic, P T =MAX( K à T , 0)
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UGBA103 Summer2008 9 Equity of a Levered Firm. Suppose a firm finances its assets, A , in part by a single, zero coupon, homogeneous issue of debt maturing at time T . The promised future value (PFV) of the debt (repayment and interest) is F . [Ex: Firm raises $1m @8% for 5 years, F =$1m(1.08) 5 ]. Note that: Because the issue is zero coupon, there are no intermediate payments Because the issue is homogeneous, all debt holders are on equal footing and no debt holder has a prior claim
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Lecture 5 - _a_ Options and Corporate Liabilities AND _b_ RNV

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