Corporate Finance

Term III, Sections E & F

Class Notes 13

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2017-March 2018
 Options

 Derive value from an underlying security

 Options – give the holder the right but not the obligation to buy or
sell a designated security at a specific price

 European Option can be exercised only at its expiration

date
 American Option can be exercised anytime up-to and
including the expiration date

 A Call Option gives the holder the right to buy a security at a

specified exercise or strike price.

 A Put Option gives the holder the right to sell a share at a specified
price
 Options – 1

Value of Call Option (assuming a European Option and no dividends) at its

expiration date is :

Vo  max( Vs  E,0)

Market price Exercise price

+ Investor

Premium (P)
Gain or 0
Loss Value of Stock
E E+P

Writer
-
 Boundaries of Option Valuation

Profit ST
Call
Option payoffs

X
Y

Market Value
Time value
Intrinsic value

A ST
E
Out-of-the-money In-the-money

loss
C0 must fall within max (S0 – E, 0) < C0 < S0.
 Interpretations
Option , Strike price S
Stock Price at Expiry P

Assume an investor holds both, a stock and an option (on that stock)
Lets analyse the payoffs :

Extra payoff from holding

Possibility Stock Payoff Option Payoff Stock instead of Option
I. P > S P P-S S
2. P < S P 0 P

Thus, the stock gives a higher payoff no matter what happens

This explains the upper diagonal, X

The lower boundary, Y is because if the option has a different value from its
intrinsic value, arbitrage will correct the situation
If the stock is worthless (A), the option is worthless too
Before expiry, there is always some chance of the option to have some value, and thus
value will lie within boundaries, A Y X.
 Some Properties & Terms

 Between the Upper (X) and Lower Bounds (Y) is contained the possible
option values
 The curvature of the relationship is convex  value of premium is
maximum at the exercise price

 Trading out of money  Stock price is less than exercise price

 Trading in money  Stock price is more than exercise price

 Trading at money  Stock price is equal to exercise price

 Determinants of Option Value

1. Stock Price

2. Exercise Price

3. Time to Expiration

4. Interest Rate

5. Volatility of Stock prices

 Determinants of Option Value – Volatility

Stock A Stock B
(Rs.) Probabilty (Rs.) Probabilty
Exercise price 38 38

Expected price 30 0.10 20 0.10

36 0.25 30 0.25
40 0.30 40 0.30
44 0.25 50 0.25
50 0.10 60 0.10

Mean 40 40
Std. Dev 15.23155 31.62278

Value : 3.3 5.8

 Binomial Lattice

0 13
 Determinants of Option Value – Time to Expiration

 Time Value of Money  longer the time to expiration lesser

the present value

 More time available for value increase

Determinants of Option Value –Interest Rate

The cost of the option can be thought of as the “initial down payment”
and the exercise price as the “final payment”

Thus higher the interest rate the lower is the present value of the future
exercise price
 Summary of Variability

Increase in Variable Option Value Change

Stock Volatility Increase

Time to Expiration Increase

Interest Rate Increase

Exercise Price Decrease

Current (at expiration) Increase

Stock Price
 Five Factors That Determine Option Values

Factor Calls Puts

Current value of the underlying asset (+) (-)

Exercise price on the option (-) (+)
Time to expiration on the option (+) (+)
Risk-free rate (+) (-)
Variance of return on underlying asset (+) (+)
 Option Pricing of a Hedged Position

With two related assets – a stock and the option on that stock – a
risk-free hedged position can be set up

This can be achieved by ensuring that price movements on each

offset each other

Assumptions :

1. European Option
2. 1 year to expiration
3. No dividends
4. No transaction costs for buying or selling stocks, or, buying or
writing options
5. Risk free rate = r
 Illustration : A Simple Two State Option
Nomenclature
1. uVs = upper value of stock (probability : q)
2. dVs = lower value of stock (probability : 1-q)
3. Risk free rate : r %
4. Current Price Vs

Risk Free Rate 5%

Current Price 50
Strike price 50
Upside 10%
Downside -10%
Periods 1

(1 + rf)^t -1 = prob. of upside * upside% + (1 - prob. of upside) * -downside%

Probability of upside: 75.00%(Risk Neutral Probability)

 Risk Neutral Probability

Price 50
Exercise Price 50

Risk free rate rf 5.00%

Periods 1
1 + upside = u 10% 1.10
1 + downside = d -10% 0.90

Estimate of upside probability , Pu 75.00%

Pd 1 - Pu 25.00%
 Option Value
Price 50
Exercise Price 50
Risk free rate rf 5.00%
Periods 1
1 + upside change = u 10% 1.10
d -10% 0.90
Estimate of probability , Pu 75.00%
Pd 1 - Pu 25.00%

Scenario Node Value Option Value Probability Exp. Value

Price Increase 55 5 75.00% 3.75
Price Decrease 45 0 25.00% 0
100.00% 3.75

Present value 3.5714286

 Option Delta

Hedge Ratio of stock to options, or, Option delta

Spread of possible option val ues

Spread of possible stock prices

Current % increase Future Option

Market Price of Price Price Values Probability
50 10% 55 5 75%
-10% 45 0 25%

uVo  dVo 50 5

Option delta    or 0.50
uVs  dVs 55  45 10

Hedging Strategy based on Option Delta, Buy 1 stocks (long position) and Write 2
options (short position). Alternately, one could buy 0.50 stocks (long position)
and write 1 call option (short position)
 Option Valuation : Duplicate a Call's Cash Flows
Buy 0.5 stocks
Sell 1 Call

Stock Price
55 45

a. Buy ONE call 5.00 0.00

OR
Assuming that we buy 
b. Buy Stock and Borrow Hedged Position times stock and write ONE
call
at Risk Free Rate

Value of Value of
long Short
Stock Price at end position in Position in Value of Combined
of period stock Option Hedged Position

55 27.5 -5 22.5
45 22.5 0 22.5
 Option Valuation : Duplicate a Call's Cash Flows
Buy stock and borrow appropriately so that value of outstanding
is the same as the hedged position at expiry date. At expiry date
the following is cash flow of the portfolio assuming the stock bought
is sold and the loan is repaid
Stock Price
55 45
Sell stock 27.50 22.50
Repay Loan -22.50 -22.50
Net 5.00 0.00

This way the same cash flow as the option is generated and thus must
have the same value.

Today this portfolio is worth :

Value of Stock purchased 25.00
Current Value of Borrowing -21.43
Value of portfolio 3.57143

Thus, Cost of Option ₹ 3.57143

 Option Valuation : Duplicate a Call's Cash Flows

Value of Call = Stock Price X Delta - Amount Borrowed

 Black – Scholes Model
It can easily be shown that in a two state model :

A Call can be duplicated by Stock and Borrowings

The assumption that there can only two outcomes cannot be held in
the real world and thus, the above ‘duplicating’ strategy too will not
work?

As it turns out, that as we take a smaller and smaller time period,

the assumption that there are only two possibilities or outcomes is
quite plausible. Black and Scholes show that a specific
combination of stock and borrowing can indeed duplicate a call
over an infinitesimal time horizon.

In the next instant, the price will change and another combination of
stock and borrowing will be applicable!!
 Black – Scholes Model (3)
E
Vo  Vs N(d1 )  rt N(d 2 )
e
Vs = Current price of stock
N(d) = Cumulative normal probability function
E = Exercise price of option
e = 2.71828
r = short term interest rate – assuming continuous compounding
t = length in time of years to the expiration of the option

ln(V s /E)  [r  12 ( 2 )]t

d1 
 t
ln(V s /E)  [r  12 ( 2 )]t
d2 
 t
ln = natural logarithm
 = standard deviation of annual rate of return on the stock continuously compounded
Note : N(d1) is the hedge ratio
 Black – Scholes Model : Interpretation

Option Value = (Option Delta X Share Price) – Loan Adjusted

Implications : Value ONLY depends on the following 

• Short Term interest

• Time to expiration
• Variance of rate of return
• Current Value
• Exercise Price

As indicated earlier, the upper bound of option value can be

shown to approach the value of the stock
 Limitations of Black and Scholes Model

1. Not amenable to simulations like those possible for the

Binomial model

2. Cannot adequately value options with dividend payments

prior to expiration

3. Cannot adequately value American Puts

 Covered Call Strategy
Buy a Stock and Sell a Call 35

30

Exercise price 30 25

20

Stock Prices 15

10

10 20 30 40 50 60
5

Value of Call 0 0 0 -10 -20 -30 0

0 10 20 30 40 50 60 70
Value of Stock 10 20 30 40 50 60
Total 10 20 30 30 30 30

35

Buy a Zero Coupon Bond and Sell a Put 30

25

Exercise price 30 20

15

Stock Prices 10

10 20 30 40 50 60 5

Value of Put -20 -10 0 0 0 0 0

0 10 20 30 40 50 60 70

Value of Zero
Coupon Bond 30 30 30 30 30 30
Total 10 20 30 30 30 30
 Protective Put

Buy one Put and one stock 70

60

Exercise price 30 50

40

Stock Prices 30

10 20 30 40 50 60 20

Value of stock 10 20 30 40 50 60
10
Value of Put 20 10 0 0 0 0
0
Total 30 30 30 40 50 60 0 10 20 30 40 50 60 70

Buy one Call and one Zero Coupon Bond 70

60

Exercise price 30 50

40

Stock Prices 30

10 20 30 40 50 60 20

Value of Call 0 0 0 10 20 30 10

Value of Zero 0
0 10 20 30 40 50 60 70
Coupon Bond 30 30 30 30 30 30
Total 30 30 30 40 50 60
 Put- Call Relationship

Price of Call
=
Price of Put + Price of Stock - Present Value of exercise Price
Buy Stock + Put Vs Sell Call + Borrow PV of Exercise Price

Risk Free Rate (r) 5% per period

Stock Price 100
Borrowing 100
Strike Price (X) 105
Price of Call 7
Price of Put 5
At Expiry Date
NOW ST < 105 ST > 105
Buy Stock -100 ST ST
Buy Put -5 +(105 - ST) 0

Borrow
X / (1 - r ) 100 -105 -105
Sell Call 7 0 -(ST - 105)

Total 2 0 0

Arbitrage will ensure that the cash flow NOW = 0

 Stocks & Bonds as Options

Call Option
1. Stockholders can be viewed as
Cash Flow to
having a call option on the firm
Shareholders 2. Bondholders ‘own’ the firm
3. If cash flow is more than the
0
liability to bond holders,
stockholders buy back the firm

Required Cash Flow to

Bondholders

Put Option

Cash Flow to 1. Stockholders own the firm

Bondholders
Total Required Cash
Flow to Bondholders
Firm Cash Flow
2. Bondholders have sold a put
option on the firm to the
shareholders
3. The exercise price of the put is
the liability to bondholders
(interest + principal)
 Stocks and Bonds as Options - 2

Stockholders Bondholders
Call Option

1. Stockholders own a call on the firm with 1. Bondholders own the firm
exercise price of the bond liability
2. Bondholders have sold a call on the firm to
the shareholders

Put Option

1. Stockholders own the firm 1. Bondholders are owed interest and principal
totalling to the shareholders' liability

2. Stockholders owe bondholders interest and 2. Bondholders have sold a put on the firm to
principal as their liability the shareholders
3. Stockholders own a put option with the
exercise price equalling to this liability
 Negotiating Restrictions and the Options Pricing Theory

• From the Lender’s perspective,

Value of Debt = min (D,V)

• From the Borrower’s perspective,

Value of common stocks = max (V-D,0)
 Since greater the risk, greater the value to shareholders, there
will be an interest to increase risks
 However with increase of risks  there will be lower values
for the lender

 Thus there could be a transfer of wealth from the lender to the

borrower.
 Need for Protective Covenants
 Executive Stock Options

Executive Stock Options (ESOP) is by far the biggest component of total

compensation for many top executives.
ESOPs provide the right to purchase a given quantity of the company’s
stock at the exercise price – which is usually the market price of the stock
at the date the option is written
Advantages

1. Align goals of senior executives with shareholders

2. Reduce base pay
3. Provide a performance link to employee remuneration
4. Tax efficient way

However, with falling stock prices and new accounting reporting

requirements, ESOPs seem to have lost some of their ‘glitter’
 Executive Stock Options- Example
E
Vo  Vs N(d1 )  rt
N(d 2 )
e
1.Exercise price (Vs)= current stock price (E) = $51.15
2.Risk free rate (r) = .07
3.Time in years to expiration (t) = 5
4.Variance (s2) = 0.1464

Vo = $23.098
Comments
1. For a large company, whose stock is actively traded in large numbers,
the value of the option would be cost to the company. For this cost,
it would gain the benefits provided earlier
2. When the stock and stock options constitute a large percentage of
an executive’s portfolio – by forcing a significant ‘freeze out’ period,
the portfolio is forced to be undiversified and thus risky
 Valuing a Start-up (1)
Business Plan (without Options)
Restaurant Business serving exotic food. Current assumption – 1 restaurant.
Year
All Future
0 1 2 3 4 Years

Sales 300,000 600,000 900,000 1,000,000 1,000,000

Capital Expenditure -700,000

Cash flow from operations -100,000 -50,000 75,000 250,000 250,000

Increase in Working Capital 50,000 20,000 10,000 10,000 0

Terminal Value 1,250,000 250,000
Net Cash Flow -700,000 -150,000 -70,000 65,000 1,490,000

Discount Rate 20%

Net Present Value -700,000 -125,000 -48,611 37,616 718,557
-117,438
Options
• Expand : (50% chance of good market conditions) – upto 30 addl.
Restaurants in 4 years
• Abandon : (50% chance of poor market conditions)
 Valuing a Start-up (2)
Key Data

1. Cost of each restaurant : 700,000

2. Number of addl restaurants : 30
3. Year of start of addl restaurants : 4
4. Risk Free rate : 3.5%
5. Average standard deviation of similar business : 0.35
6. Estimate standard deviation of present business : 0.50
Capital Expenditure (year 4) 21,000,000 Exercise Price

NPV of operating cash flow 8,428,266 Value of underlying asset

(as of now)

Value of option : 1,454,273

Value of business : 1,454,273 – 117,439 = 1,336,835
 Binomial Options

Refer to text book for a simple example + Excel sheet on Binomial

Options