This chapter serves as an introduction to options.
The most familiar options are puts and calls. These options give the holder the right to sell or buy shares of common stock at a given exercise price. American options can be exercised any time up to and including the expiration date. European options can be exercised only on the expiration date.
We showed that a strategy of buying a stock and buying a put is equivalent to a strategy of buying a call and buying a zero coupon bond. From this, the put–call parity relationship was established:
Value of stock + Value of put – Value of call = Present value of exercise price
The value of an option depends on five factors:
The price of the underlying asset.
The exercise price.
The expiration date.
The variability of the underlying asset.
The interest rate on risk-free bonds.
The Black–Scholes model can determine the intrinsic price of an option from these five factors.
Much of corporate financial theory can be presented in terms of options. In this chapter, we pointed out that:
Common stock can be represented as a call option on the firm.
Stockholders enhance the value of their call by increasing the risk of their firm.
Real projects have hidden options that enhance value.
