ch20 - Chapter 20 Options and Corporate Finance Learning...

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Chapter 20 Options and Corporate Finance Learning Objectives 1. Define a call option and a put option, and describe the payoff function for each of these options. 2. List and describe the variables that affect the value of an option. Calculate the value of a call option and of a put option. 3. Name some of the real options that occur in business and explain why traditional NPV analysis does not accurately incorporate their values. 4. Describe how the agency costs of debt and equity are related to options. 5. Explain how options can be used to manage a firm’s exposure to risk. I. Chapter Outline 20.1 Financial Options A financial option is a derivative security in that its value is derived from the value of another asset. The owner of a financial option has the right, but not the obligation, to buy or sell an asset on or before a specified date for a specified price. The asset that the owner has a right to buy or sell is known as the underlying asset .
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The last date on which an option can be exercised is called the exercise date or expiration date , and the price at which the option holder can buy or sell the asset is called the exercise price or strike price . A. Call Options A call option gives the owner the right to buy, or “call,” the underlying asset. Once the asset price goes above the exercise price, the value of the call option at exercise increases dollar for dollar with the price of the underlying asset. The buyer pays the seller a fee to purchase the option. This fee, which is known as the call premium , makes the total return to the seller positive when the price of the underlying asset is near or below the exercise price. B. Put Options The owner of a put option has the right to sell the underlying asset at a prespecified price. The payoff function for the owner of a put option is similar to that for a call option, but it is the reverse in the sense that the owner of a put option profits if the price of the underlying asset is below the exercise price. The owner of a put option will not want to exercise that option if the price of the underlying asset is above the exercise price. When the value of the underlying asset is below the exercise price, however, the owner of the put option will find it profitable to exercise the option. The payoff for the seller of the put option is negative when the price of the underlying asset is below the exercise price.
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The seller of a put option hopes to profit from the fee, or put premium , that he or she receives from the buyer of the put option. C. American, European, and Bermudan Options Options that can only be exercised on the expiration date are known as European options . American options
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ch20 - Chapter 20 Options and Corporate Finance Learning...

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