Chapter 25

Options and Corporate

Securities

© 2016 McGraw-Hill Education Limited

 Key Concepts and Skills
• Know the basics of call and put options and how to
calculate their payoffs and profits
• Understand the factors that affect option values and how
to price call and put options using no arbitrage conditions
• Understand the basics of employee stock options and
their benefits and disadvantages
• Know how to value a firm’s equity as an option on the
firm’s assets and use option valuation to evaluate capital
budgeting projects
• Understand convertible bonds and warrants and how to
value them

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 Chapter Outline
• Options: The Basics
• Fundamentals of Option Valuation
• Valuing a Call Option
• Employee Stock Options
• Equity as a Call Option on the Firm’s Assets
• Warrants
• Convertible Bonds
• Reasons For Issuing Warrants and Convertibles
• Other Options
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LO1
Option Terminology 25.1
• Call Options
• Give the Buyer the right but not the obligation to buy an asset at
the Exercise Price on or before the Expiration Date
• Put Options
• Give the Buyer the right but not the obligation to sell an asset at
the Exercise Price on or before the Expiration Date
• Strike or Exercise price
• The price at which you can buy (Call) or sell (Put) the underlying
asset
• Expiration date
• The date at which the option expires & become worthless
• Most equity options expire on the third Friday of the expiry month

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 Option Terminology 25.1
• Premium
• The price the buyer pays to the writer upon the initiation of the
option.
• Writer
• There are two parties to every option contract.
• Buyers have rights but not obligations
• Writers only have obligations
• American Option
• Can be exercised at any point during its life
• European Option
• Can be exercised only on the expiry date

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 More About Expiry Dates
• All options are assigned to one of the following cycles.
• Air Canada is in Cycle 1

• LEAPs (Long Equity Anticipation Participation Securities)

expire in January
• LEAPs can be up to three years long
• https://www.m-x.ca/f_publications_en/cycles_opt_en.pdf
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Air Canada Call Options

30-day historical
volatility: 39.12%

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Air Canada Put Options

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LO1
Stock Option Quotations
• Things to notice
• Call options with Exercise Prices less than the current price are
worth more than the corresponding puts
• Call options with Exercise Prices greater than the current price
are worth less than the corresponding puts

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LO1
Option Payoffs – Calls 25.2

Call Option Payoff

• The value of the call at Diagram
expiration is the intrinsic value
20
• C1 = Max(0, S1 - E)
• If S1<E, then the payoff is 0 15

Call Value
• If S1>E, then the payoff is S1 – E 10
Where:
5
C1 = Value of the call at expiration
S1 = Value of the stock on the expiration 0
date 0 10 20 30 40 50 60
E = The Exercise Price Stock Price
Assume that the exercise
price is $35

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LO1
Option Payoffs - Puts
Payoff Diagram for Put
• The value of a put at Options
expiration is the intrinsic
value 40
• P1 = Max (0, E – S1)

Option Value
30
• If S1<E, then the payoff is E-S1
• If S1>E, then the payoff is 0 20
10
Where:
P1 = Value of the put at expiration 0
S1 = Value of the stock on the expiration 0 10 20 30 40 50 60
date Stock Price
E = The Exercise Price Assume that the exercise
price is $35

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 Three Things to Know About
Call Options
• Call Options
1. Maximum profit
• Unlimited
2. Maximum loss
• Premium
3. Rule for Exercise
• Exercise iff (if and only if) the stock price is greater
than the Exercise Price

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 Three Things to Know About
Put Options
• Put Options
1. Maximum profit
• Exercise price minus Premium
2. Maximum loss
• Premium
3. Rule for Exercise
• Exercise iff (if and only if) the stock price is less
than the Exercise Price

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LO2
Call Option Bounds
• Upper bound
• Call price must be less than or equal to the stock price
• You would never pay more for the “right to buy something” than
you would pay to buy it directly
• Lower bound
• Call price must be greater than or equal to the stock price minus
the exercise price or zero, whichever is greater
• If this were not true, there would be a riskless profit opportunity
• If either of these bounds are violated, there is an
arbitrage opportunity

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LO2
Figure 25.3 – Value of a call option
before expiration

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LO2
A Simple Model
• An option is “in-the-money” if:
• Call: If S0 > E
• Put: If S0 < E
• If a call option is sure to finish in-the-money, the
option value would be
• C0 = S0 – PV(E)
• If the call is worth something other than this, then
there is an arbitrage opportunity

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LO2
What Determines Option
Values?
• Stock price
• As the stock price increases, the call price increases and the put
price decreases
• Exercise price
• As the exercise price increases, the call price decreases and the
put price increases
• Time to expiration
• Generally, as the time to expiration increases both the call and
the put prices increase
• Risk-free rate
• As the risk-free rate increases, the call price increases and the
put price decreases

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LO2
What about Variance? 25.3
• The variance in underlying asset returns is a less
obvious, but important, determinant of option values
• The greater the variance, the more the call and the put
are worth
• If an option finishes out-of-the-money, the most you can lose is
your premium, no matter how far out it is
• The more an option is in-the-money, the greater the gain
• You gain from volatility on the upside, but don’t lose anymore
from volatility on the downside

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LO2
Table 25.1 – Five factors that
determine option values

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Black Scholes Option Pricing
Model

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LO4
Employee Stock Options 25.4
• Options that are given to employees as part of
their benefits package
• Often used as a bonus or incentive
• Designed to align employee interests with stockholder
interests and reduce agency problems
• Empirical evidence suggests that they don’t work as
well as anticipated due to the lack of diversification
introduced into the employees’ portfolios
• The stock just isn’t worth as much to the employee as
it is to an outside investor

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LO4
Executive Compensation in Canada
Figure 25.4

Company CEO Base Salary & Share-Based Option-Based Pension & Other Total Reported
Bonus Awards Awards Compensation Compensation

BlackBerry Ltd. John Chen $1,025,506 $88,689,513 $0 $0 $89,715,019

Magna International Donald $11,993,567 $7,757,165 $3,473,275 $193,267 $23,417,274

Inc. Walker

Onex Corp. Gerald $21,135,946 $0 $0 $0 $21,135,946

Schwartz

Canadian Pacific Hunter $9,711,292 $3,662,444 $3,661,937 $596,496 $17,632,169

Railway Ltd. Harrison

Catamaran Corp. Mark Thierer $3,451,188 $10,943,301 $1,894,012 $41,966 $16,330,467

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LO3
Equity: A Call Option 25.5
• Common stock can be viewed as a call option on
the company’s assets with the Exercise Price
equal to the face value of the firm’s debt
• If the assets are worth more than the debt, when
the debt comes due, the option will be exercised
and the stockholders retain their ownership
• If the assets are worth less than the face value of
the debt, when the debt comes due, the
stockholders will let the option expire and
ownership of the assets will pass to the
bondholders

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LO5
Warrants 25.6
• A security that gives the holder the right to purchase
shares of stock at a fixed price over a given period of
time
• It is a call option issued by corporations in conjunction
with other securities (Bonds or Preferred Shares) to
reduce the cost
• Usually included with a new issue as a sweetener or
equity kicker
• As of March 27, 2017 there are 54 Warrants trading on
the TSX

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LO5
Differences between warrants and
traditional call options
• Warrants are generally long term (years, not
months )
• They are written by the company and exercise
results in additional shares being issued out of
treasury
• The exercise price is paid to the company and
generates cash for the firm
• Warrants can be detached from the original
securities and sold separately

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LO5
Convertible Bonds 25.7
• Convertible bonds (or preferred stock) may be
converted into a specified number of common
shares at the option of the security holder
• The conversion price is the effective price paid
for the stock. It is the dollar amount of a bond’s
par value that is exchangeable for one share of
stock
• Example: If a $1,000 bond is convertible into 100
common shares (the conversion ratio), the conversion
price is $10

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LO5
Convertibles – continued
• The Conversion Ratio - the number of shares
received when the bond is converted
• Example: If a $1,000 bond is convertible into common
stock at $10 per share, the conversion ratio is 100
• Conversion Premium – The difference between
the conversion price and the current stock price
divided by the current stock price
• Example: If the stock is trading at $12 and the
conversion price is $10, the conversion premium is
20%
• Straight Bond Value – The value of a convertible
bond if it could not be converted into common
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LO5
Convertibles – continued
• Floor Value – The higher of the straight
bond value or the conversion value
• Prior to maturity, convertible bonds will be
worth more than the floor value

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 Figure 25.5 – Minimum value of a convertible
LO5 bond versus the value of the stock for a given
YTM

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LO5
Figure 25.6 – Value of a convertible bond versus
value of the stock

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LO5
Valuing Convertibles
• Suppose you have a 10% bond that pays semi-annual
coupons and will mature in 15 years. The face value is
$1,000 and the yield to maturity on similar bonds is 9%.
The bond is also convertible with a conversion price of
$100. The stock is currently selling for $110. What is the
minimum price of the bond?

• Straight bond value = $1,081.44 1,000 FV

• Conversion ratio = 1000/100 = 10 100 ÷ 2 = PMT
• Conversion value = 10*110 = $1,100 15 x 2 = N
• Minimum price = $1,100 9÷2= I
CPT PV $1,081.44

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LO5
Reasons for Issuing Warrants and
Convertibles 25.8
• They allow companies to issue cheaper
debt by attaching sweeteners to the new
issue.
• They give companies the chance to issue
common stock in the future at a premium
over current prices

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LO5
Table 25.3 – The case for and
against convertibles

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LO5
Other Options 25.9
• Call provision on a bond
• Allows the company to repurchase the bond
prior to maturity at a specified price that is
generally higher than the face value

• Put bond
• Gives the bond holder the right to sell the
bond back to the issuer prior to maturity at a
fixed price

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LO5
Other Options continued
• Over allotment option
• Also known as the Greenshoe Option
• Underwriters have the right to purchase
additional shares from a firm in an IPO
(chapter 15)
• Insurance and Loan Guarantees
• These are essentially put options
• Managerial (real) options

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 Quick Quiz
• What is the difference between a call option and
a put option?
• What is the intrinsic value of call and put options
and what do the payoff diagrams look like?
• What are the five major determinants of option
prices and their relationships to option prices?
• What are some of the major capital budgeting
options?
• How would you value a convertible bond?

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 Summary 25.10
• The most familiar options are puts and calls. The holder
has the right, but not the obligation, to sell (buy) the
underlying asset at a given price on or before a given
date
• There are five factors that impact an options value: price
of underlying, exercise price, expiration date, risk-free
interest rate, and volatility
• Warrants given the holder the right to buy shares directly
from the company at a fixed price for a specified period of
time
• Convertible bonds are a combination of a straight bond
and a call option, both of which will affect the minimum
value of the bond

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