Session 12 - Options, Real and Financial, Chapter 8

All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage Learning, 2020)

Chapter 8

This chapter is about financial options.  However, this course is concerned with real options rather than financial options.  We do this chapter to allow us to discuss and detect the real options that are discussed in Chapter 11. 

Need to Absorb -  Definitions and terms related to options, such as put, call, long, short,  in-the-money, at-the-money, out-of-the-money, strike, exercise price, real  option, etc. Be able to compute the value at expiration, and net profit for puts and calls in both long and short positions.  Be able to compute the value of a call option or put option using  a 1-period binomial option pricing model.  Be able to compute the value  of assets, calls, puts, and bonds using the put-call parity formula. Be aware  of the inputs into valuing options as listed with the Black-Scholes Options Pricing Model. When given information on real options, be able to identify the  type of option, who is long, who is short, the underlying asset, the exercise  price, and sometimes the premium.

Do not need to Absorb - You will not be asked to value options using the Black-Scholes Options Pricing Model on exams. 

Need to Read - Read the chapter.  Be prepared to do some Internet searches if  you need additional information.

Need to Do - Make 100 on the Quiz.  Be able to answer End of Chapter Questions 1-3, Problems 1, 2, 4, 6, 7.

1. Watch  the Chapter Overview video.  The Powerpoints for all of this chapter's videos are  located here.  This topic is new to many people and is a very different way of thinking about valuation and accept/reject decisions.  You should  download my handout on real options, A useful  handout on Real Options. You will probably need my videos in  addition to the textbook to understand this material. If my materials and the  textbook are not sufficient, the Chicago Board Options Exchange (CBOE) has  some basic  tutorials on financial options. Be prepared to do some Internet searches if  you need additional information.

2. Read pages 343-353.  Watch  the Options Terms and Concepts video (minicase page 369-370, parts a&b). After viewing the video, be able to answer end of chapter Question 1.

3. Read pages 353-357.  Watch  the Payoff Diagrams and the Binomial Option Pricing Model (minicase c and d1-3).  Everything in this video is testable.  After viewing the  video, be able to answer end of chapter Self Test 1 and Problems 6 and 7.

5. Read the rest of the chapter.  If you feel the need, watch  the  Portfolio Replication Binomial Model and the Black Scholes Option Pricing Model (minicase d4 and e) video.  You will not need to compute this model on the exam.  This videos is important as it mentions the five factors that affect option valuation.  After viewing the  video, be able to answer Self-Test 2 and Problem 5.

6. Watch the  Parameter Impacts and Put-Call Parity Model (minicase f and g) video.  Everything in this video is testable.  After viewing the  video, be able to answer end of chapter Problems 4 and be able to answer the remaining end of chapter questions and  problems.  Identifying Real Options is a useful skill for both this chapter and Chapter 11, if you are still having difficulty identifying real options, watch the video on Spotting Real Options. 

7. If you need  additional instruction, here are audio solutions to the most common types of  Option Valuation type questions;

a. Suppose you believe that Du Pont's stock price is going to  decline from its current level of $84.39 sometime during the next 5 months. For  $396.18 you could buy a 5-month put option giving you the right to sell 100  shares at a price of $82 per share. If you bought a 100-share contract for  $396.18 and Du Pont's stock price actually changed to $86.79, your net profit  (or loss) after exercising the option would be ______?

b. Suppose you believe that Du Pont's stock price is going to  decline from its current level of $84.46 sometime during the next 5 months. For  $517.89 you could buy a 5-month put option giving you the right to sell 100  shares at a price of $85 per share. If you bought a 100-share contract for  $517.89 and Du Pont's stock price actually changed to $75.30, your net profit  (or loss) after exercising the option would be ______?

c.Suppose you believe that Du Pont's stock price is going to increase from its current level of $84.39 sometime during the next 5 months. For $396.18 you could sell/write a 5-month put option giving you the obligation to buy 100 shares at a price of $82 per share. If you sold a 100-share contract for $396.18 and Du Pont's stock price actually changed to $86.79, your net profit (or loss) after exercising the option would be ______? 

c. Suppose you believe that Bennett Environmental's stock price is  going to increase from its current level of $31.09 sometime during the next 7  months. For $535.00 you could buy a 7-month call option giving you the right to  buy 100 shares at a price of $28 per share. If you bought a 100-share contract  for $535.00 and Bennett's stock price actually changed to $32.62, your net  profit (or loss) after exercising the option would be ______?

d. The current price of a stock is $62.60 and the annual effective  risk-free rate is 3.8 percent. A call option with an exercise price of $55 and  one year until expiration has a current value of $13.23. What is the value of a  put option written on the stock with the same exercise price and expiration date  as the call option?

e. The current price of a stock is $54.98 and the annual risk-free  rate is 4.3 percent. A put option with an exercise price of $55 and one year  until expiration has a current value of $3.61. What is the value of a call  option written on the stock with the same exercise price and expiration date as  the put option?

f. The assets of Blue Light Specials are currently worth $2,100. These assets are expected to be worth either $1,800 or $2,300 one year from now. The company has a pure discount bond outstanding with a $2,000 face value and a maturity date of one year. The risk-free rate is 5%. What is the value of the equity in this firm? 

g. You own one call option with an exercise price of $30 on Nadia Interiors stock. This stock is currently selling for $27.80 a share but is expected to increase to either $28 or $34 a share over the next year. The risk-free rate of return is 5% and the inflation rate is 3%. What is the current value of your option if it expires in one year?

8. Be able to answer  the suggested End of Chapter questions and problems. Be prepared for a  moderately long quiz. Mathwise, this is a difficult quiz.

Revised March 25, 2021