Introduction to Corporate Finance

ParT 2: ValuaTION, rISk aNd reTurN

CitiGroup does warn investors to note that they

are not entitled to any dividends, distributions

or other rights that may be payable to genuine

full holders of the underlying asset; a warrant is

not quite the same as actually possessing the

underlying asset.

Sources: Adapted from CitiFirst Trading Warrants, Product Disclosure

Statement, Equity Call and Put Warrants, 2 November 2012. Issued by

Citigroup Global Markets Australia Pty. Limited. Used with permission.

ASX. http://www.asx.com.au/PDF/15-037CTW.pdf. Accessed 29 September 2015.

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

describe the basic features of call and put

options

construct payoff diagrams for individual

options as well as portfolios of options and

other securities

explain qualitatively what factors are

important in determining option prices

calculate the price of an option, using the

binomial model

list several corporate finance applications

of option pricing theory.

LO8.1

LO8.2

LO8.3

LO8.4

LO8.5

A bit of folk wisdom says, ‘Always keep your options

open.’ This implies that choices, both now and in

the future, have value; and that having the right to

do something is better than being obliged to do it.

This chapter shows how to apply that intuition to

financial instruments called options. Options allow

investors to buy or to sell an asset at a fixed price,

for a given period of time. Having the right to buy

or sell shares at a fixed price can be valuable – as

long as there is a chance that the share price can

move in the right direction.

Many commentators see options merely as a

form of legalised gambling for the rich. We strongly

disagree with that perspective. Options exist

because they provide real economic benefits that

come in many different forms.

First, as part of the compensation package

for managers, options provide incentives for

managers to take actions that increase their

companies’ share prices, thereby increasing

the wealth of shareholders. Some point out

that abuses may occur when organisations

award excessive option grants, or employees

take improper actions to inflate share prices

and option values. However, we see this as a

corporate governance problem, not a problem

with options per se.

Second, a wide variety of options exist to

allow holders the right to buy and to sell many

different types of assets, not just ordinary

shares. Sometimes, trading the option is more

cost effective than trading the underlying

asset. For example, trading a share index

option, which grants the right to buy or to sell a

portfolio of shares such as the ASX200, enables

investors to benefit from market movements

while avoiding paying all of the transactions

costs that would result from trading 200

individual shares.

Third, companies use options to reduce their

exposure to certain types of risk. Companies

regularly buy and sell options to shelter their cash

flows from movements in exchange rates, interest

rates and commodity prices. In that function,

options resemble insurance much more than they

resemble gambling.