Corporate Finance II

Lecture 4: Contingent Claims II: Valuation

Slides by: Andrew Lepone Updated by: Hui Zheng

Admin
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Topics Covered
Calls and Puts Relevance to Corporate Finance Exercise and Option Payoff Diagrams

Put call Parity Methods of Option Valuation

Option Terminology
Call option - Right to buy an asset at a specified exercise price on or before the maturity (expiry) date.

Put option - Right to sell an asset at a specified exercise price on or before the maturity date. Example

Option Terminology
European option - An option that can be exercised only at the maturity date. American option - An option that can be exercised on, or at anytime before, the maturity date.

Long or Short the Underlying?

Long positions make money when prices of the underlying asset go up
Short positions make money when prices of the underlying asset go down

Call

Put

Buyer Right to buy (LONG call & asset) Right to sell (LONG put, SHORT asset)

Writer Obligation to sell (SHORT call & asset) Obligation to buy (SHORT put LONG asset)

Options and Corporate Finance

Risk Management
Eg. New Issues, Interest rates, Exchange rates

Companies issue options, or securities with embedded options, to raise finance

Eg. Warrants and Convertibles

Shares in a levered firm can be regarded as an option on the assets Real options are embedded in projects
Eg. Timing of harvesting a forest.

Option Exercise Value

The value of an option at expiration is a function of the asset price P and the exercise price Ex.
Call Exercise value = Max (0, P Ex) Put Exercise value = Max (0, Ex P)

Exercise Values
Example - CSR Option exercise values given an exercise or strike price of $4.50 Payoff: Call=Max [0, P-Ex]; Put= Max [0, Ex-P]

Share Price

$3.00

3.50
0

4.00
0

4.50
0

5.00
0.50

5.50
1.00

Call Exercise Value 0

Put Exercise Value 1.50

1.00

0.50

Option Payoff (Not Profit)

Call option exercise payoff or position (NOT profit!!) diagram given a $4.50 exercise price. Unlimited upside Call option exercise value

Slope =1 $1

Share Price

4.50

5.50

Option Payoff
Put option payoff diagram given a $4.50 exercise price. Put option exercise value Maximum payoff =$4.50

Slope = -1

$0.50 4.00 4.50

Share Price

Option Payoff
Call Option SELLERS (writers) payoff given a $4.50 exercise price. Written call payoff Share Price Mirror image of call payoff

$4.50

Option Payoff
Written (short) put payoff given a $4.50 exercise price. Written put option payoff Share Price

$4.50

Share Payoff (Position)

Long Share Position

Position Value

Slope =1

Share Price

Share Plus Put Payoff

To put floor under the share price: Buy the share and a put option - Protective Put
Long Share Position Long Put Position Value

Share Price

Share Plus Put

Protective Put - Buy the share and hold a put option
Combined payoff

Position Value

Long Share Position

Long Put

Share Price

Share plus Bond

Buy call and buy a bond with value = PV(Exercise)
Long call
Position Value

Long bond

Share Price

Share plus Bond

Long call plus long bond with value PV(Exercise) Identical to protective put

Position Value

Share Price

Conclusion
If you:
1. buy the share, and 2. buy a put option you can get the same payoff by: 1. buying a call option with an identical maturity and exercise price to the put, and 2. investing sufficient money in a bond to pay for the exercise price at maturity.

Identical Outcomes
In both positions the same outcome results:
P > Ex end up holding the share P< Ex end up with cash equal to Ex P = Ex share and cash of Ex are equivalent

Put Call Parity

Since the payoffs of the two positions are identical, the value of the two positions must also be identical (i.e. value of investment). Therefore: Value of call + present value of exercise price = Value of put + share price This relationship is called put call parity.

Straddle
Straddle - Long call and long put - Strategy for payoff from high volatility

Straddle Position Value

Share Price

Straddle Profits
You get a positive payoff from a straddle as long as the share price changes. But you only make a profit if the option is underpriced (too cheap).
Eg. Other market participants underestimate the volatility.

Option Equivalent
Combining ordinary share investment and borrowing to replicate the option payoff = option equivalent. Net cost of buying the option equivalent = value of the option.

Example of Option Equivalent

In January 1996 you purchase six-month call options on CSR shares with an exercise price of $4.50. Current share price is $4.50. The interest rate is 3.75% for six months. Assume that the share price will either fall by 10% to $4.05 or rise by 20% to $5.40 by June 1996.

Possible payoffs of the option: Share price = $4.05 Share price = $5.40

$0

$0.90

Example of Option Equivalent

You can create a call option equivalent by : 1. buying delta (d) shares and 2. borrowing to help finance that purchase Pick delta (hedge ratio) and the amount borrowed to replicate the possible option payoffs. You want to make your delta share position give you a spread of payoffs equal to the spread of option payoffs.

Example of Option Equivalent

Spread of possible option prices 1) Option delta Spread of possible share prices 0.90 - 0) 5.40 - 4.05) 2 or 0.66 3
Therefore you buy 2/3 of one share in CSR

Example of Option Equivalent

(2) Work out the borrowing required to equate the option payoff and the payoff from holding 2/3 of a share.
Therefore: Borrow the PV of $2.70

Share Price $4.05 Two-thirds of one share Option payoff Repayment of loan & interest $2.70 0 $2.70

Share Price $5.40 $3.60 $0.90 $2.70

Example of Option Equivalent

$2.70 Amount to borrow 1.0375 $2.60 bank loan

Example of Option Equivalent

Value of call Value of levered investment Value of 2 of a share - Bank loan 3 $4.50 x 2 - $2.60 3 $0.40

CSR Risk Neutral Example

In January 1996 you purchase six-month call options on CSR shares with an exercise price equal the current price of $4.50. The interest rate is 3.75% for six months. Assume that the share price will either fall by 10% to $4.05 or rise by 20% to $5.40 by June 1996. Risk Neutral (RN) world: Expected return on CSR shares = rf = 3.75% 3.75% = (RN prob up)(20%) + (1 RN prob up)(-10%) So RN prob up = 0.4583

Risk Neutral Valuation

Exercise price $4.50 Current Price $4.50 Future Share Price $4.05 or $5.40 Option Payoff $0.00 or $0.90

Expected payoff =(0.4583)(0.90)+(0.5417)(0) RN Prob up = 0.4125 DCF value = 0.4125/(1.0375) = $0.40 Easy, provided you can get RN probabilities!

Risk Neutral Probabilities with discrete price changes

Probability of a rise

upside change% - downside change% )

interest rate% - downside change% )

3.75 - - 10)) q 0.4583 20 - -10))

Probability of a fall = 1- q

The Cone of Uncertainty

Pt HIGH

P0

And possibilities in between

Pt LOW

Higher s widens the cone

Multiple Period Valuation

Multiple application of the single period calculations. Using the single period result:

1 d u

Note: Rf = % p.a.

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Option Pricing Models

There is a problem with our simple option equivalent calculations:
there are likely to be many more than two possible share prices at maturity therefore there are more than two possible option payoffs to consider

Two popular solutions

Use a lattice to approximate the possibilities: Eg. Binomial method
As we make the individual time periods Shorter, the lattice becomes finer and the approximation gets better. Time

Assume a distribution for prices (returns) and specify the stochastic process accompanying that distribution Eg. Black Scholes Model (next week)

Multiple Period Valuation 1(T /n ) 2(T /n ) 3(T /n ) (n 1) (T /n )T

Figure: An n period binomial lattice for an option maturing at time = T .

Multiple Period Valuation

Lets make matters concrete. Let

S0 = 100, T = 0.25, X = 100, = 30%p.a., Rf = 10%p.a., and n = 5.

Consequently,

Multiple Period Valuation

139.85 130.78 122.29 114.36 106.94 106.94 114.36 106.94 122.29

100
93.51

100
93.51 87.44

100
93.51 87.44

81.77
76.47

81.77
71.5

Figure: The underlying security price tree.

Multiple Period Valuation

max[ST X , 0] 31.25 14.83 3.85 0 139.85 100 = 39.85 122.29 100 = 22.29 106.94 100 = 6.94 0

7.45

11.26
3.41

16.49

23.24

5.73
0.96

9.37
1.85

0
0

Figure: Call option values

Multiple Period Valuation

How to get $31.25?

Put option valuation is as above, except the terminal node payoffs are given by max[X ST , 0]

Early Exercise Decisions

How about if stock pays dividends?

Illustration A company pays a dividend of $D

u (uS D ) d (uS D )
u (dS D ) d (dS D )

uS D
dS D

Figure: A binomial lattice with discrete dividend.

Early Exercise Decisions

Dividends (or similar cash flows) play a role in American option valuation.

Dividends can be:

1

lumpy (discrete) e.g a $ amount every 6 months (e.g. a single firms dividend) smooth (continuous) e.g. a constant yield every period (e.g. dividends flowing from a large portfolio of firms)

In the case of lumpy dividends, the recombining property of the lattice gets broken Note: American Option Valuation Use the same binomial approach as before with one variation:
At each node we compare the calculated option value with the value from exercising and choose the largest of these two values.