2201AFE VW Week 13 Options & Revision for Final Exam S1, 2013

7/27/2019 2201AFE VW Week 13 Options & Revision for Final Exam S1, 2013

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2201AFE Corporate FinanceWeek 13:

Options

Final Exam Revision

Readings: Chapter 20


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Agenda

Last Week

Options Key Concepts and Skills

Final Exam Comments and Revision

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Last Lecture

Dividends matter

Chronology of dividend payment Ex-dividend Date

Dividend Policy doesnt matter (in theory)

Homemade dividends

Clientele effect

In real life policy matters (low/high payouts)

Information content effect signalling to the market

Types of dividend policies

Share repurchases, splits, reverse splits

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1. Introduction & Financial

Statements

2. Time Value of Money

3. Valuing Shares & Bonds

7. Mid-semester Exam

8. Some Lessons from Capital

Market History

11. Financial Leverage & Capital

Structure Policy

13. Options & Revision

9. Return, Risk & the Security

Market Line

5. Making Capital Investment

Decisions & Project Analysis

12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

4. Net Present Value & Other

Investment Criteria

10. Cost of Capital


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Key Concepts and Skills

Options: The Basics

Contract characteristics

Options Payoffs

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Option Terminology

Call option

Right without the obligation to BUY a specified asset at a specified price

on or before a specified date.

Put option

Right without the obligation to SELL a specified asset at a specified price

on or before a specified date.

Option premium

The price paid by the buyer/seller for the right to buy or sell an asset.

Strike or Exercise price

The contracted price at which the underlying asset can be bought (call)

or sold (put).

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Option Terminology

Option contract counterparties: buyer and seller

An investor who SELLS the option the option writer, holds a SHORT

position in the contract.

An investor who BUYS the option holds a LONG position in the

contract.

Expiration date

The date at which an option expires. (See more here:http://www.asx.com.au/products/futures-options-expiry-calendars.htm )

European option

An option that can only be exercised on a particular date (on expiry).

American option

An option that can be exercised at any time up to its expiry date.

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Option Terminology

Exercising the option

The act of buying or selling the underlying asset via the option contract.

Contract size

Open Interest

Number of open positions (bought and sold) in the market place.

Provides an estimate of market liquidity, the higher the open interest,

the more liquid the market.

Interested? Read more here:

http://www.asx.com.au/products/asx-grain-futures-and-options-trading-strategies.htm

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Option Valuation

ST

= Share price at expiration

S0 = Share price today

Cor P = Value of call/put option on expiration

C0 or P0= Value of call/put option today

E= Exercise price on the option

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Value of Option

At the money:

Stock price equals exercise price (no profit/loss).

Out-of-the-money:

Option has no intrinsic value (make a loss).

In-the-money:

Option has intrinsic value (make a profit).

Intrinsic value:

The value of the option if exercised it immediately.

Call: Stock price Exercise price > 0

Put: Exercise price stock price > 0

The time premium or time value component:

The difference between the option premium and the intrinsic value.

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Value of Call Option (C0)

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Share price

(S0)

Call option value (C0)

S0 E

Out of the moneyS0 > E

In the money

Exercise price (E)

S0 = E

At the money

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Value of Call

Intrinsic ValueTime value

Upper bound = C0

S0Lower bound = The larger of 0 or (S0E)


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Value of Call and Put Option at Expiry (C & P)

At time T:

If the call is in-the-money, it is worth: C = ST E.

If the call is out-of-the-money, it is worthless: C = 0

If the put is in-the-money, it is worth: P = E ST.

If the put is out-of-the-money, it is worthless: P = 0

Where

ST

is the value of the stock at expiry (time T)

Eis the exercise price.

C is the value of the call option at expiry

P is the value of put option at expiry

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Call Option Payoffs for Buyer

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20

12020 40 60 80 100

40

20

40

60

Stock price ($)

Ca

llpayoff($)

50

Exercise price: E = $50

If share at expiration: ST = $80, ST = $20

Buyer payoff: max[ST E,0] max[ST E,0]

max[80-50,0]=30 max[20-50,0]=0


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Call Option Payoffs for Seller

15

20

12020 40 60 80 100

40

20

40

60

Stock price ($)

OptionP

ayoff($)

50



Seller payoff: -max[ST-E,0] -max[ST-E,0]

-max[80 50,0] = -$30 -max[20 50,0] = 0


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Call Option Profits/Losses

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Exercise price: E =$50Option premium: C0 = $10

If ST = $80

Sell a call

Loss = +10 +50-80 = -20

Buy a call

Profit = -10 -50 + 80 = 20

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12020 40 60 80 100

40

20

40

60

Stock price ($)

Op

tionpayoffs($)

50

10

10


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Put Option Payoffs for Buyer

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20

0 20 40 60 80 100

40

20

0

40

60

Stock price ($)

Optionpayoffs($)

Buy a put

50

50



Buyer payoff: max[E ST,0] max[E ST,0]

max[50 20,0] = $30 max[50 80,0]= 0


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Put Option Payoffs for Seller

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20

0 20 40 60 80 100

40

20

0

40

50

Stock price ($)Optio

npayoffs($)

Sell a put

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Seller payoff: -max[E ST,0] -max[E ST,0]

-max[50-20,0]= -$30 -max[50 80,0] = 0


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Put Option Profits

19

20

20 40 60 80 100

40

20

40

60

Stock price ($)

O

ptionpayoffs($)

Buy a putProfit = -10 - 20 + 50 = 20


Option premium: P0 = $10

If ST = $20

10

10

Sell a put

Loss = +10 + 20 50 = -20

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Conclusion

Options are valuable financial instruments

Increases upside potential

Reduces or limits the downside

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Revision

Course Revision

Recap in more details the chapters

Quiz

Exam instructions, venue and structure

How to study for the exam

Additional consultation times

Final comments

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Week 5 (part 2)

Chapter 9: Project Analysis and Evaluation

Evaluation of NPV Estimates

Scenario Analysis

Sensitivity Analysis

Simulation Analysis

Break-even

Accounting

Cash

Financial

Operating Leverage

Other consideration in Capital Budgeting

Managerial options

Capital rationing

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W k 8


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Week 8

Chapter 10: Some Lessons from Capital Market History

How to calculate investment return

Arithmetic and Geometric Averages

How to measure risk

Variance

Standard Deviation

Lessons from Capital Market History

Risk Premium

Risk-Return Relationship

Efficient Market Hypothesis25


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W k 9


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Week 9

Chapter 11: Return, Risk and the Security Market Line

Expected Return with unequal probabilities

Variance with unequal probabilities

Portfolio Expected Return

Portfolio Variance

Principle of Diversification

Systematic and Unsystematic risk

CAPM and SML

Reward-to-Risk Ratio

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Week 10


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Week 10

Chapter 17: Cost of Capital

Discount rate of the firm

Target capital structure: D/E

Cost of Equity

DGM & CAPM

Cost of Debt

YTM

Weighted Average Cost of Capital WACC

Unadjusted, Adjusted, use in NPV

Flotation costs31


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Week 11


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Week 11

Chapter 19: Capital Structure Policy

Optimal Capital Structure

Value of the firm

Cost of capital

Capital Structure Theory Three cases Case I No taxes

Case II With taxes

Case III With taxes and Bankruptcy Costs

Types of Bankruptcy Costs

Direct and Indirect

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Week 12


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Week 12

Chapter 18: Dividends & Dividend Policy

Irrelevance of dividend policy

Homemade Dividends

Real world factors

Information content effect signalling

Clientele effect

Types of dividend policies

Residual, Constant Div. Growth, Constant Payout, Compromise, DRP

Stock splits, stock dividends and repurchases

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Week 13


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Week 13

Chapter 20: Options

Basic concepts

Call

Put

Terminology

Option Payoffs

Buyer

Seller

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Quiz


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Break-even analysis shows the relationship between.?

Do we use GM or AM in variance calculation?

What is Beta, Systematic or Unsystematic Risk?

What is the value of market Beta?

If an asset is undervalued, where should it be located with respect of

the SML?

To maximise value of the firm, WACC should be maximised or

minimised?

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Quiz


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If a firm has debt and taxes, what happens to the cost of capital as

D/E increases? What case and proposition is this?

Does dividend policy matter in theory?

What happens to the share price in a reverse split?

When would you buy a call?

If the underlying share price is decreasing the put seller makes a loss

or a profit?

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Exam Instructions


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2.5 hours examination on (Thursday) 20 June 2013 at 8.30AM

All chapters starting Week 5 (part 2) covered

No specific calculations from first half, however know the basic concepts

10 minutes perusal

During perusal, you can only write on the exam paper!

Closed Book

Dont bring the formula sheet with you!

Materials allowed:

Non-Programmable Scientific calculator English Translation Dictionary

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Exam Venues


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QSAC_Track & Field Room, Qld Sport & Athletics Centre

(Ground Floor or Level 1)

QSAC Venue & Parking Map:

http://www.qsac.com.au/The-Venue/Location.aspx

http://www.qsac.com.au/getattachment/The-Venue/Venue-Map/QSAC-Venue-Map.pdf.aspx

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Break down on time
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8.00AM Arrive at your exam venue.

8.30AM Perusal start (may write on exam paper only).

8.40AM Start of Final Exam.

No one may leave in the first 30 minutes.

9.10AM Hero to be the first to exit venue (may be zero too).

. . . . . . .

11.00AMLast 10 minutes, no one may leave (no more toilet breaks).

11.10AMEnd of Exam, pens down and time to study for next exam.

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Exam Structure


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Question 1 is compulsory and is worth 17 marks.

All students must attempt Question 1.

Attempt any threequestions from the remaining five.

Questions 2 to 6 are worth 11 marks each.

Total marks for exam = 17 + (3 11) = 50

Show step by step workings and formula used.

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Exam Structure


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Question 1. (a), (b), (c), (d), (e).

Answer ONLY 3 of remaining 5 questions.

Question 2. (a), (b), (c), (d).

Question 3. (a), (b), (c). Question 4. (a), (b), (c), (d).

Question 5. (a), (b), (c).

Question 6. (a), (b), (c).

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How to Study?


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Practice! Practice! Practice!

Tutorial and practice questions

Lecture examples Chapter examples

Read Lecture Notes

Read the chapters in the text, definitions

Theory questions can be from anywhere!

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Consultation Times

l d d k


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Consultation during study week:

Please check Learning@GU under Announcement for more

details.

No appointment/booking required if you are seeing us during

these times. If you cannot make it to uni, try and contact your

tutor via email.

Please bring your questions during consultation, we are here to

help you learn.

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Good luck for your exams!

If you have any questions, please see any of our teaching team.

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2201AFE VW Week 13 Options & Revision for Final Exam S1, 2013

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