LECTURE 4

CH 22: OPTIONS AND CORPORATE

FINANCE

22-1
 KEY CONCEPTS AND SKILLS
• Understand option terminology
• Be able to determine option payoffs and profits
• Understand the major determinants of option prices
• Understand and apply put-call parity
• Be able to determine option prices using the binomial and Black-Scholes
models

22-2
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Option Quotes

22.6 Combinations of Options

22.7 Valuing Options
22.8 An Option Pricing Formula

22.9 Stocks and Bonds as Options

Application: VIX, distance to default (KMV model)

22-3
 22.1 OPTIONS
• An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or before) a
given date, at prices agreed upon today.
• Exercising the Option
• The act of buying or selling the underlying asset

• Strike Price or Exercise Price

• Refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset
• Expiry (Expiration Date)
• The maturity date of the option

22-4
 OPTIONS
• European versus American options
• European options can be exercised only at expiry.
• American options can be exercised at any time up to expiry.

• In-the-Money
• Exercising the option would result in a positive payoff.

• At-the-Money
• Exercising the option would result in a zero payoff (i.e., exercise
price equal to spot price).
• Out-of-the-Money
• Exercising the option would result in a negative payoff.

22-5
 22.2 CALL OPTIONS
• A call option gives the holder the right, but not the obligation, to buy
a given quantity of some asset on or before some time in the future,
i.e. before the expiration date at a price (the exercise or strike price)
agreed upon today.

• For example, call options on IBM stock can be purchased on the

Chicago Board Options Exchange.
• IBM does not issue call options on its common stock. Instead, individual
investors are the original buyers and sellers of call options on IBM
common stock.
• Suppose it is April 1. A representative call option on IBM stock enables
an investor to buy 100 shares of IBM on or before Sep. 19 at an exercise
price of $100. This is a valuable option if there is some probability that
the price of IBM common stock will exceed $100 on or before Sep. 19.

22-6
 CALL OPTION PRICING AT EXPIRY
• At expiry, an American call option is worth the same as a European option
with the same characteristics.
• If the call is in-the-money, it is worth ST – E.
• If the call is out-of-the-money, it is worthless:

C = Max[ST – E, 0]

Where
ST is the value of the stock at expiry (time T)

E is the exercise price.

C is the value of the call option at expiry

22-7
 CALL OPTION PAYOFFS
60

all
Option payoffs ($)

ac
y
Bu
40

20

20 40 60 80 100 120
Stock price ($)
–20

–40 Exercise price = $60

22-8
 CALL OPTION PROFITS
60
Option profits ($)

Buy a call
40

20
10

20 40 60 70 80 100 120
–10 Stock price ($)
–20

Exercise price = $60; option premium = $10

–40

22-9
22.3 PUT OPTIONS
• A put option gives the holder the right, but not the obligation, to
sell a given quantity of an asset on or before some time in the
future, at prices agreed upon today.

• Assume that the exercise price of the put is $50 and the stock price at
expiration is $40.
• The owner of this put option has the right to sell the stock for more than
it is worth.
• That is, he can buy the stock at the market price of $40 and immediately
sell it at the exercise price of $50, generating a profit of $10 (=$50 −
$40). Thus, the value of the option at expiration must be $10.

22-10
 PUT OPTION PRICING AT EXPIRY
• AT EXPIRY, AN AMERICAN PUT OPTION IS WORTH THE SAME AS A
EUROPEAN OPTION WITH THE SAME CHARACTERISTICS.

• IF THE PUT IS IN-THE-MONEY, IT IS WORTH E – ST.

• IF THE PUT IS OUT-OF-THE-MONEY, IT IS WORTHLESS.

P = MAX[E – ST, 0]

22-11
 PUT OPTION PAYOFFS

60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

22-12
 PUT OPTION PROFITS
60
Option profits ($)

40

20

10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10

22-13
 OPTION VALUE

• INTRINSIC VALUE
• CALL: MAX[ST – E, 0]
• PUT: MAX[E – ST , 0]

• TIME VALUE
• THE DIFFERENCE BETWEEN THE OPTION PREMIUM AND THE INTRINSIC VALUE OF THE
OPTION.

Option Intrinsic Time

Premium = Value
+ Value

22-14
 22.4 SELLING OPTIONS
• The seller (or writer) of an option has an obligation.
• The seller receives the option premium in exchange.

• Chicago Board Options Exchange: www.cboe.com

• NASDAQ: www.nasdaq.com
• Euronext: www.euronext.com

22-15
 CALL OPTION PAYOFFS
60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20 Se
ll
ac
Exercise price = $50
all
–40

22-16
 PUT OPTION PAYOFFS
40
Option payoffs ($)

20

Sell a put
0
0 20 40 60 80 100
50
Stock price ($)
–20

–40 Exercise price = $50

–50

22-17
 OPTION DIAGRAMS REVISITED
Option profits ($)

40 Bu Buy a call
y
ap
ut

Sell a call
10 Sell a put

Stock price ($)

Buy a call 40 50 60 100
–10 Buy a put

u t
a p
l l
Se
Exercise price = $50;
–40 Sell a call
option premium = $10

22-18
 22.5 OPTION QUOTES
CALL PUT
Option/Strike Exp. Vol. Last Vol. Last
Pepsi 82.5 Oct 3 4.80 4 2.1
85.7 82.5 Jan 14 5.50 65 3.15
85.7 85.0 May 371 0.83 63 0.05
85.7 85.0 Jun 51 1.60 303 1.28
85.7 87.5 Jun 487 0.53 1,012 2.86
85.7 87.5 Jul 369 0.99 28 3.15

22-19
 22.5 OPTION QUOTES
This option has a strike price of $85
CALL PUT
Option/Strike Exp. Vol. Last Vol. Last
Pepsi 82.5 Oct 3 4.80 4 2.1
85.7 82.5 Jan 14 5.50 65 3.15
85.7 85.0 May 371 0.83 63 0.05
85.7 85.0 Jun 51 1.60 303 1.28
85.7 87.5 Jun 487 0.53 1,012 2.86
85.7 87.5 Jul 369 0.99 28 3.15
Last traded price for the stock is $85.70
May is the expiration month.

22-20
 22.5 OPTION QUOTES

CALL PUT
Option/Strike Exp. Vol. Last Vol. Last
Pepsi 82.5 Oct 3 4.80 4 2.1
85.7 82.5 Jan 14 5.50 65 3.15
85.7 85.0 May 371 0.83 63 0.05
85.7 85.0 Jun 51 1.60 303 1.28
85.7 87.5 Jun 487 0.53 1,012 2.86
85.7 87.5 Jul 369 0.99 28 3.15

Puts with this exercise price are out-of-the-money.

22-21
 22.5 OPTION QUOTES

CALL PUT
Option/Strike Exp. Vol. Last Vol. Last
Pepsi 82.5 Oct 3 4.80 4 2.1
85.7 82.5 Jan 14 5.50 65 3.15
85.7 85.0 May 371 0.83 63 0.05
85.7 85.0 Jun 51 1.60 303 1.28
85.7 87.5 Jun 487 0.53 1,012 2.86
85.7 87.5 Jul 369 0.99 28 3.15

371 call options with this exercise price were traded that day.

22-22
 22.5 OPTION QUOTES

CALL PUT
Option/Strike Exp. Vol. Last Vol. Last
Pepsi 82.5 Oct 3 4.80 4 2.1
85.7 82.5 Jan 14 5.50 65 3.15
85.7 85.0 May 371 0.83 63 0.05
85.7 85.0 Jun 51 1.60 303 1.28
85.7 87.5 Jun 487 0.53 1,012 2.86
85.7 87.5 Jul 369 0.99 28 3.15

Since the option is on 100 shares of stock, buying this option

would cost $83 plus commissions.

22-23
 22.6 COMBINATIONS OF OPTIONS
• Puts and calls can serve as the building
blocks for more complex option contracts.
• If you understand this, you can become a
financial engineer, tailoring the risk-return
profile to meet your client’s needs.

22-24
PROTECTIVE PUT STRATEGY (PAYOFFS)

Value at Protective Put payoffs

expiry

$50

Buy the
stock Buy a put with an exercise
price of $50

$0
Value of
$50
stock at
expiry
22-25
 PROTECTIVE PUT STRATEGY (PROFITS)
Value at Buy the stock at $40
expiry
$40 Protective Put
strategy has
downside protection
and upside potential

Value of
$0
stock at
-$10 expiry
$40 $50
Buy a put with exercise price of $50
for $10

-$40

22-26
 COVERED CALL STRATEGY
Value at Buy the stock at $40
expiry

$10 Covered Call strategy

$0
Value of stock at expiry

$40 $50
Sell a call with exercise price
of $40 for $10
-$30
-$40

22-27
 LONG STRADDLE
Option payoffs ($)

40 Buy a call with exercise

price of $50 for $10
30

Stock price ($)

30 40 60 70
Buy a put with exercise
–20
price of $50 for $10

$50
A Long Straddle only makes money if the stock price moves
$20 away from $50.

22-28
 SHORT STRADDLE
This Short Straddle only loses money if the stock
price moves $20 away from $50.
Option payoffs ($)

20
Sell a put with exercise price of
$50 for $10
Stock price ($)
30 40 60 70
$50

–30
Sell a call with an
–40 exercise price of $50 for $10

22-29
 PUT-CALL PARITY: P0 + S0 = C0 + E/(1+ R)T
E Portfolio payoff
Portfolio value today = C0 +
(1+ r)T
Option payoffs ($)

Call

25 bond

25 Stock price ($)

Consider the payoffs from holding a portfolio consisting of a call

with a strike price of $25 and a bond with a future value of $25.

22-30
 PUT-CALL PARITY
Portfolio payoff
Portfolio value today = P0 + S0
Option payoffs ($)

25

Stock price ($)

25
Consider the payoffs from holding a portfolio consisting of
a share of stock and a put with a $25 strike.

22-31
 PUT-CALL PARITY
Portfolio value today Portfolio value today
Option payoffs ($)

Option payoffs ($)

E = P0 + S 0
= C0 +
(1+ r)T

25 25

25 Stock price ($) Stock price ($)

25

Since these portfolios have identical payoffs, they must have the
same value today: hence
Put-Call Parity: C0 + E/(1+r)T = P0 + S0

22-32
 PUT-CALL PARITY
E.g. Suppose shares of stock in Siem Ltd. are selling for $110. A
call option on Siem with one year to maturity and a $110 strike
price sells for $15. A put with the same terms sells for $5. What's
the risk-free rate?

To answer, we need to use put–call parity to determine the price of

a risk-free, zero coupon bond:

Price of underlying stock + Price of put − Price of call = Present

value of exercise price

Plugging in the numbers, we get:

$110 + $5 − $15 = $100

Because the present value of the $110 strike price is $100, the
implied risk-free rate is 10 percent.

22-33
22.7 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.

• Intuitive explanation
• Three methods:
• Binominal tree
• Risk-neutral probability
• Black-scholes model

22-34
LOWER BOUND
• Assume that the stock price is $60 and the exercise price is
$50. In this case the option cannot sell below $10.
Otherwise there is an arbitrage.
• The price of the option is likely to be above $10, because
of the possibility that the stock will rise above $60 before
expiration.
• In this case the intrinsic value of the option is $10, whereas
the remaining $2 is called time premium or time value.
• Time value of the options decays over time.

22-35
 UPPER BOUND
• The upper boundary is the price of the underlying stock.

• An option to buy common stock cannot have a greater

value than the common stock itself.

22-36
 AMERICAN CALL

Profit ST
Option payoffs ($)

Call

25
Market Value
Time value
Intrinsic value

ST
E
Out-of-the-money In-the-money
loss
C0 must fall within max (S0 – E, 0) < C0 < S0.

22-37
OPTION VALUE DETERMINANTS

22-38
• Volatility: The Variability of the Underlying Asset: The greater the
variability of the underlying asset, the more valuable the call option will
be.

• Suppose that just before the call expires, the stock price will be either
$100 with probability .5 or $80 with probability .5. What will be the
value of a call with an exercise price of $110?
• -worthless
• Suppose we add $20 to the best case and take $20 away from the
worst case. Now the stock has a one-half chance of being worth $60
and a one-half chance of being worth $120. The expected value of the
stock has stayed the same.
• -Notice that the call option has value now because there is a one-half
chance that the stock price will be $120, or $10 above the exercise
price of $110.
• How about for put option ? 22-39
• Interest Rate: Buyers of calls do not pay the exercise price until
they exercise the option, if they do so at all. The ability to delay
payment is more valuable when interest rates are high and less
valuable when interest rates are low.
• In the case of a stock split, the exercise price of the option is
adjusted accordingly. For example, if a $20 stock has a two-for-
one split, the stock will trade at the new price of $10. If I hold
one option with an exercise price of $20, I will end up with two
options with an exercise price of $10 each, and an unchanged
net position.
• If the underlying asset pays a dividend, this will also impact the
option price, as it is negatively related to the call value and
positive related to the put value.

22-40
 22.8 AN OPTION PRICING FORMULA

• We will start with a binomial option pricing formula

to build our intuition.

• Then we will graduate to the normal approximation

to the binomial for some real-world option
valuation.

22-41
 BINOMIAL OPTION PRICING MODEL

Suppose a stock is worth $25 today and in one period will either be worth 15%
more or 15% less. S0= $25 today, and in one year S1 is either $28.75 or $21.25.
The risk-free rate is 5%. What is the value of an at-the-money call option?

S0 S1
$28.75 = $25×(1.15)

$25

$21.25 = $25×(1 –.15)

22-42
 BINOMIAL OPTION PRICING MODEL
1. A call option on this stock with exercise price of $25 will have
the following payoffs.
2. We can replicate the payoffs of the call option with a levered
position in the stock.
S0 S1 C1
$28.75 $3.75

$25

$21.25 $0

22-43
 BINOMIAL OPTION PRICING MODEL
Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either $7.50
or $0.
The levered equity portfolio has twice the option’s payoff, so the portfolio
is worth twice the call option value.
S0 (S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
22-44
 BINOMIAL OPTION PRICING MODEL
The value today of the levered equity
portfolio is today’s value of one share $ 21.25
less the present value of a $21.25 debt: $ 25 −
(1+ 𝑅 𝑓 )
S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0

22-45
 BINOMIAL OPTION PRICING MODEL

1
( $ 21.25
)
We can value the call option today as half
of the value of the levered equity portfolio: 𝐶 0 = $ 25 −
2 (1+ 𝑅 𝑓 )

S0 ( S1 – debt portfolio
)= C1
$28.75 – $21.25 = $7.50 $3.75

$25

$21.25 – $21.25 = $0 $0
22-46
 BINOMIAL OPTION PRICING MODEL

If the interest rate is 5%, the call is worth:

1
(
𝐶 0 = $ 25 −
2
$ 21.25 1
)
= ( $ 25 −20.24 )=$ 2.38
(1.05) 2

C0 S0 ( S1 – debt ) = portfolio C1
$28.75 – $21.25 = $7.50 $3.75

$2.38 $25

$21.25 – $21.25 = $0 $0

22-47
 BINOMIAL OPTION PRICING MODEL
The most important lesson (so far) from the
binomial option pricing model is:

THE REPLICATING PORTFOLIO INTUITION.

Many derivative securities can be valued by
valuing portfolios of primitive securities when
those portfolios have the same payoffs as the
derivative securities.

22-48
 DELTA
• This practice of the construction of a riskless hedge is called delta
hedging.
• The delta of a call option is positive.
• Recall from the example:

Swing of call $ 3.75 − 0 $ 3.75 1

D ¿ =
Swing of stock $ 28.75 − $ 21.25 $ 7.5 2
=
=
• The delta of a put option is negative.

22-49
 DELTA
• DETERMINING THE AMOUNT OF BORROWING:

1
(
𝐶 0 = $ 25 −
2
$ 21.25 1
)
= ( $ 25− $ 20.24 )=$ 2.38
(1.05) 2
VALUE OF A CALL = STOCK PRICE × DELTA
– AMOUNT BORROWED
$2.38 = $25 × ½ – AMOUNT BORROWED
AMOUNT BORROWED = $10.12

22-50
THE RISK-NEUTRAL APPROACH
𝑞 × 𝑉 ( 𝑈 ) + ( 1 −𝑞 ) ×𝑉 ( 𝐷)
𝑉 ( 0) =
(1+ 𝑅 𝑓 )
S(U), V(U)
q

S(0), V(0)

1- q
S(D), V(D)

WE COULD VALUE THE OPTION, V(0), AS THE VALUE OF THE REPLICATING

PORTFOLIO. AN EQUIVALENT METHOD IS RISK-NEUTRAL VALUATION:

22-51
THE RISK-NEUTRAL APPROACH
S(0) IS THE VALUE OF THE UNDERLYING ASSET
TODAY.
S(U), V(U)
q
q is the risk-neutral
S(0), V(0) probability of an
“up” move.
1- q
S(D), V(D)
S(U) and S(D) are the values of the asset in the next period
following an up move and a down move, respectively.
V(U) and V(D) are the values of the option in the next period
following an up move and a down move, respectively.

22-52
 THE RISK-NEUTRAL APPROACH

S(U), V(U)
q
𝑞 × 𝑉 ( 𝑈 ) + ( 1 −𝑞 ) ×𝑉 ( 𝐷)
S(0), V(0) 𝑉 ( 0) =
(1+ 𝑅 𝑓 )
1- q
S(D), V(D)

• THE KEY TO FINDING Q IS TO NOTE THAT IT IS ALREADY IMPOUNDED

INTO AN OBSERVABLE SECURITY PRICE: THE VALUE OF S(0):
𝑞 × 𝑆 ( 𝑈 ) + ( 1− 𝑞 ) × 𝑆( 𝐷)
𝑆 ( 0 )=
(1+ 𝑅 𝑓 )
(1+𝑅 𝑓 )× 𝑆(0)− 𝑆(𝐷)
A minor bit of algebra yields: 𝑞=
𝑆 (𝑈)− 𝑆(𝐷)
22-53
 EXAMPLE OF RISK-NEUTRAL VALUATION
Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. The risk-free rate is
5%. What is the value of an at-the-money call option?
The binomial tree would look like this:
$ 28.75=$ 25 ×(1+.15)

$28.75,C(U)
q
$25,C(0) $ 21.25=$ 25 ×(1 −.15)

1- q $21.25,C(D)

22-54
 EXAMPLE OF RISK-NEUTRAL VALUATION
The next step would be to compute the risk neutral
probabilities
( 1+ 𝑅 𝑓 ) × 𝑆 ( 0 ) − 𝑆( 𝐷)
𝑞=
𝑆 ( 𝑈 ) − 𝑆( 𝐷)
( 1+.05 ) × $ 25 − $ 21.25 $5 2
𝑞= = =
$ 28.75 − $ 21.25 $ 7.50 3

2/3 $28.75,C(U)

$25,C(0)

1/3
$21.25,C(D)

22-55
 EXAMPLE OF RISK-NEUTRAL VALUATION
After THAT, FIND THE VALUE OF THE CALL IN THE UP STATE AND DOWN
STATE.

𝐶(𝑈 )=$ 28.75− $ 25

2/3 $28.75, $3.75

$25,C(0) 𝐶(𝐷)=max [¿$ 25− $28.75,0]¿

1/3
$21.25, $0

22-56
 EXAMPLE OF RISK-NEUTRAL VALUATION
Finally, find the value of the call at time 0:
𝑞×𝐶(𝑈)+(1− 𝑞)× 𝐶(𝐷)
𝐶(0)=
(1+ 𝑅 𝑓 )

2/3 × $ 3.75 +(1/3)× $ 0

𝐶(0)=
(1.05)

$ 2.50 2/3 $28.75,$3.75

𝐶(0)= =$ 2.38
(1.05)
$25,C(0)
$25,$2.38

1/3
$21.25, $0

22-57
 RISK-NEUTRAL VALUATION AND THE
REPLICATING PORTFOLIO
This risk-neutral result is consistent with valuing the call using
a replicating portfolio.

2/3 × $ 3.75+(1/3)× $ 0 $ 2.50

𝐶0 = = =$ 2.38
(1.05) 1.05

1
(
𝐶 0 = $ 25 −
2
$ 21.25 1
(1.05) )
= ( $ 25 −20.24 )=$ 2.38
2

22-58
 THE BLACK-SCHOLES MODEL
−𝑅𝑡
𝐶 0 =𝑆 × N (¿ 𝑑1 )− 𝐸 𝑒 × N (¿ 𝑑 2 )¿ ¿
Where
C0 = the value of a European option at time t = 0
R = the risk-free interest rate.
2
σ N(d) = Probability that a
(¿ 𝑆/ 𝐸)+(𝑅+ )𝑡
2 standardized, normally
𝑑1=ln ¿ distributed, random
𝜎 √𝑡
variable will be less than
𝑑2 =𝑑 1 − 𝜎 √ 𝑡 or equal to d.
The Black-Scholes Model allows us to value options in the
real world just as we have done in the 2-state world.

22-59
22-60
22-61
 THE BLACK-SCHOLES MODEL
• Find the value of a six-month call option on Hardcraft,
Inc. with an exercise price of $150.
• The current value of a share of Hardcraft is $160.
• The interest rate available in the U.S. is R = 5%.
• The option maturity is 6 months (half of a year).
• The volatility of the underlying asset is 30% per annum.

• Before we start, note that the intrinsic value of the

option is $10—our answer must be at least that amount.
22-62
 THE BLACK-SCHOLES MODEL
LET’S TRY OUR HAND AT USING THE MODEL. IF YOU HAVE A CALCULATOR
HANDY, FOLLOW ALONG.

First calculate d1 and d2

2
(¿ 𝑆/ 𝐸)+(𝑅+.5 σ )𝑡
𝑑1=ln ¿
𝜎 √𝑡

𝑑1=ln(¿ 160/150)+¿ ¿ ¿
Then,
𝑑2 =𝑑 1 − 𝜎 √ 𝑡=0.52815 − 0.30 √ .5=0.31602

22-63
THE BLACK-SCHOLES MODEL
−𝑅𝑡
𝐶 0 =𝑆 × N (¿ 𝑑1 )− 𝐸 𝑒 × N (¿ 𝑑 2 )¿ ¿

𝑑1=0.52815 N(d1) = N(0.52815) = 0.7013

𝑑2 =0.31602 N(d2) = N(0.31602) = 0.62401

−.05×.5
𝐶0 =$160×0.7013−150𝑒 ×0.62401

22-64
 SUMMARY
• Basic terminology of options
• Call vs put
• Underlying assets, strike price, expiration date
• American vs European option

• Combination of options and/or stock

• Call-put parity P0 + S0 = C0 + E/(1+ r)T

• Option valuation
Swing of call
• Binomial tree : Delta D
= Swing of stock

𝑞 × 𝑉 ( 𝑈 ) + ( 1 −𝑞 ) ×𝑉 ( 𝐷)
• Risk-neutral valuation 𝑉 ( 0) =
(1+ 𝑅 𝑓 )

• Black-Scholes model 2
σ
𝐶 0 =𝑆× N (¿ 𝑑1 )− 𝐸 𝑒
−𝑅𝑡
× N (¿𝑑 2 )¿¿ (¿𝑆 /𝐸)+(𝑅± )𝑡
2
𝑑1 , 2=ln ¿ 22-65
 APPLICATION OF OPTION VALUATION

• 1. VIX Index
• 2. stock and bond as option (22.9)
• 3. merge and acquisition valuation (22.10)
• 4. Options and capital budgeting (22.10)

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 VIX (CBOE VOLATILITY INDEX)
• The VIX Index is a financial benchmark designed to be an up-to-the-
minute market estimate of expected volatility of the S&P 500 Index,
and is calculated by using the midpoint of real-time S&P 500® Index
(SPX) option bid/ask quotes. More specifically, the VIX Index is
intended to provide an instantaneous measure of how much the
market thinks the S&P 500 Index will fluctuate in the 30 days from the
time of each tick of the VIX Index.
• https://www.cboe.com/tradable_products/vix/faqs/?
gclid=EAIaIQobChMI_KCz5uu77wIVideWCh19ZQSsEAAYASABEgIHPvD_
BwE&gclsrc=aw.ds

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 STOCKS AND BONDS AS OPTIONS
• The southern Cross Company has been awarded the concession at next year’s
Olympic Games in Antarctica. Because firm’s principals live in Antarctica and
because there is no other concession business on that continent, their enterprise
will disband after the games. The firm has issued debt to help finance this
venture. Interest and principal due on the debt next year will be $800, at which
time debt will be paid off in full. The firm’s cash flows next year are forecast as
follows:
Very successful Moderately Moderately Outright
game successful game unsuccessful game failure

Cash flow before interest $1000 $850 $700 $550

and principal
- Interest and principal -800 -800 -700 -550
Cash flow to stockholders $200 $50 $0 $0

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 LEVERED EQUITY IS A CALL OPTION.
• The underlying asset comprises the assets of the firm.
• The strike price is the payoff of the bond.
• For debtholder:
• They own the firm
• They have written a call on the firm with an exercise price of debt par value (i.e. 800)
• Lend 800 debt;

• For stockholder:
• Own a call option with exercise price of $800
• Borrow 800 debt;
• If at the maturity of their debt, the assets of the firm are greater in value than
the debt, the shareholders have an in-the-money call. They will pay the
bondholders and “call in” the assets of the firm.
• If at the maturity of the debt the shareholders have an out-of-the-money call,
they will not pay the bondholders (i.e. the shareholders will declare
bankruptcy) and let the call expire.

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 LEVERED EQUITY IS A PUT OPTION.
• The underlying asset comprises the assets of the firm.
• The strike price is the payoff of the bond.
• Stockholder:
• They own the firm
• They own a put option on the firm with exercise price of $800
• They owe $800 to bondholder
• Bondholder:
• seller of the put option
• Lend $800 to stockholder

• If at the maturity of their debt, the assets of the firm are less in value than the
debt, shareholders have an in-the-money put. They will put the firm to the
bondholders.
• If at the maturity of the debt the shareholders have an out-of-the-money put, they
will not exercise the option (i.e. NOT declare bankruptcy) and let the put expire.

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 STOCKS AND BONDS AS OPTIONS
• IT ALL COMES DOWN TO PUT-CALL PARITY.
E
C 0 = S 0 + P0 –
(1+ R)t
Value of a Value of a Value of a
Value of the
call on the put on the risk-free
= firm + – bond
firm firm

Stockholder’s Stockholder’s position in terms

position in terms of of put options
call options

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DISTANCE TO DEFAULT (KMV MODEL)

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 SUMMARY
• What is the difference between call and put options?
• What are the major determinants of option prices?
• What is put-call parity? What would happen if it does
not hold?
• What is the Black-Scholes option pricing model?
• How can equity be viewed as a call/put option?
• Should a firm do a merger for diversification purposes
only? Why or why not?
• Should management ever accept a negative NPV
project? If yes, under what circumstances?

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 PRACTICE QUESTIONS(UPDATED)

• CONCEPT QUESTIONS: 1, 3, 4, 12, 14

• QUESTIONS AND PROBLEMS : 1, 6, 11, 16, 38

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