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    Lecture 4

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    funinternet
    This document provides an overview and summary of lecture material on contingent claims valuation. Key points include: - The lecture covers calls, puts, exercise payoff diagrams, put-call parity, and methods of option valuation including the binomial model. - Examples are provided to illustrate option terminology, long and short positions, the relevance of options to corporate finance, exercise value, and option payoff diagrams. - The document also summarizes how to value options using a binomial lattice approach with multiple time periods, and notes how dividends can impact valuation of American options.

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    Lecture 4

    Uploaded by

    funinternet
    39 views44 pages
    This document provides an overview and summary of lecture material on contingent claims valuation. Key points include: - The lecture covers calls, puts, exercise payoff diagrams, put-call parity, and methods of option valuation including the binomial model. - Examples are provided to illustrate option terminology, long and short positions, the relevance of options to corporate finance, exercise value, and option payoff diagrams. - The document also summarizes how to value options using a binomial lattice approach with multiple time periods, and notes how dividends can impact valuation of American options.

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    This document provides an overview and summary of lecture material on contingent claims valuation. Key points include: - The lecture covers calls, puts, exercise payoff diagrams, put-call parity, and methods of option valuation including the binomial model. - Examples are provided to illustrate option terminology, long and short positions, the relevance of options to corporate finance, exercise value, and option payoff diagrams. - The document also summarizes how to value options using a binomial lattice approach with multiple time periods, and notes how dividends can impact valuation of American options.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    39 views44 pages

    Lecture 4

    Uploaded by

    funinternet
    This document provides an overview and summary of lecture material on contingent claims valuation. Key points include: - The lecture covers calls, puts, exercise payoff diagrams, put-call parity, and methods of option valuation including the binomial model. - Examples are provided to illustrate option terminology, long and short positions, the relevance of options to corporate finance, exercise value, and option payoff diagrams. - The document also summarizes how to value options using a binomial lattice approach with multiple time periods, and notes how dividends can impact valuation of American options.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 44

    Corporate Finance II

    Lecture 4: Contingent Claims II: Valuation

    Slides by: Andrew Lepone Updated by: Hui Zheng

    Admin
    Your second homework hand-in is due next week (week starting 26 August) This is to motivate you to actively engage in learning and help you prepare early for the midterm exam, which is due in two weeks time. As a reminder, your technical questions should go to your tutor first. You should feel comfortable to ask questions related to tutorial questions or textbook Dont forget the two hour consultation time is there for you Every Week throughout the semester There will be extra consultation time Every Day when it approaches the midterm exam day. Details will be posted on Blackboard

    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.

    Semester 2 2006

    44 / 81

    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.

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