Chapter 25

All page numbers are references to Fundamentals of Corporate Finance, 12th edition by Ross, Westerfield, and Jordan (McGraw Hill, 2019)

Things to Absorb

• For Chapter 25, focus on valuation using put-call parity (equity as a call option) and the inputs to the Black-Scholes Options Pricing Model. You must be able to compute the value of assets, calls, puts, and bonds using the put-call parity formula. You need to understand both the math and the implications of Chapters 24 and 25.   Be able to recognize some of the real options described in Chapter 25 such as Protective Puts, Mergers and Diversification, and Equity and Risky Debt expressed in options terms.  I will not place a Black-Scholes Option Pricing Model valuation on the Final Exam, but will have them in the Quizzes, and expect you to know the five inputs and how changing an input affects the value of the four option positions.  You are not required to know/use terms such as delta, rho, vega, and theta.

• Things to Read

• Read Chapters and 24 and 25. Be prepared to do some Internet searches where if you need additional information.
• Read handout. Be prepared to do some Internet searches where if you need additional information.

• Things to Do

Make 100 on the Chapter 25 Quiz. Be able to answer Concepts Review 1-10, and end of chapter Questions and Problems 1-6, 12, 16-20, 22 and 24. Some of the problems take many steps to solve. Note, many of the problems may require extended periods of quiet contemplation. 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 (www.cboe.com) has some basic tutorials on financial options.  I regard End of Chapter Problems 3-6, 12, 16 and 17 as exam level questions.  

• Read the Chapter Summary for Chapter 24 (page 820) and 250 (pages 854-855). Watch the Chapter Overview video. The Powerpoints for all of this chapter's videos are located here
• Read pages 829-834. Watch the video on Put Call Parity and Protective Puts. After viewing the video, you should be able to answer Concepts Review and end of chapter Problems related to Put Call Parity.
• Read the rest of the Chapter. You should the video onBlack Scholes Options Pricing Model and Delta variables.  Based on your level of interest, you can decide on the other three videos for this chapter.   Not very interesting or testable is the video on Theta (relates to changes in time to expiration), Vega (relates to changes in standard deviation) , Rho (relates to changes in the risk free rate), and Implied Standard Deviation. Interesting, but not very testable, is the video on Equity as a Call Option to Valuing Diversifying Mergers and their impact on Stock Values. Interesting and testable is the video on Equity as a Call Option showing How NPV and Project Volatility impact Capital Budgeting Decisions, along with a Concepts Review and a Comprehensive Problem. (rwjch2506)
• After reading the chapter and watching the videos, you should be able to answer the remaining suggested Chapter 25 Concepts Review, Questions and Problems.
• Here is a bonus video on Recognizing Real and Hidden Options from another book. The PowerPoints for all of this video is located here, starting at about slide 62.  Here is another bonus video on Spotting Real Options, no PowerPoints are needed for this video.
• If you need additional instruction, here are audio solutions to the most common types of Option Valuation type questions:
• 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 ______? | Review Video Solution
• 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 ______? | Review Video Solution
• 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 ______? | Review Video Solution
• 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 ______? | Review Video Solution
• 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? | Review Video Solution
• 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? | Review Audio Solution
• 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? | Review Audio Solution
• 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? | Review Audio Solution
• Be able to answer the suggested End of Chapter questions and problems. Be prepared for a moderately long quiz on Chapter 25. Mathwise, this is a difficult quiz.