8: Optionsderivative security
A security that derives its
value from another asset
underlying asset
The asset from which an
option or other derivative
security derives its value
call option
An option that grants the right
to buy an underlying asset at a
fixed price
strike price
The price at which an option
holder can buy or sell the
underlying asset
exercise price
The price at which an option
holder can buy or sell the
underlying assetFourth, options facilitate the creation of
innovative trading strategies. For instance,
suppose that an investor is following a
pharmaceutical company that has a genetically
engineered cancer drug in clinical trials. The
company has invested vast resources in this
project, so much so that its future depends
entirely on the outcome of these trials. If the tests
are successful, the company’s share price will
skyrocket. If not, the company may go bankrupt.
An investor with choices limited to buying or
selling the company’s shares must guess whether
the clinical trials will succeed or fail. As we will
see, an investor who can buy and sell options
can construct a trading strategy to profit from
a large movement in the company’s share price
regardless of whether that movement is up or
down.
Why does a chapter on options belong in
a corporate finance textbook? We offer three
answers. First, employees of large and small
corporations regularly receive options as part of
their compensation. It is valuable for both the
employees and the employers to understand
the value of this component of pay packages.
Second, companies often raise capital by issuingsecurities with embedded options. For example,
companies can issue bonds that are convertible
into ordinary shares. Valuing these bonds
requires an understanding of option pricing and
is not simply a matter of calculating the present
value of their interest and principal payments.
Third, many capital budgeting projects have
characteristics similar to options. The net present
value (NPV) method, discussed in Chapters 9–11,
can generate incorrect accept/reject decisions
for projects with downstream options. The best
way to develop the ability to recognise which real
investment projects have embedded options and
which ones do not is to become an expert on
ordinary financial options.
We begin this chapter with a brief description of
the most common types of share options and their
essential characteristics. Next, we turn our attention
to portfolios of options, illustrating how options can
be used to construct unique trading strategies and
gaining insight into how prices of different kinds
of options are linked together in the market. The
rest of the chapter examines factors that influence
option prices, and we introduce a simple, yet
powerful, tool for pricing many different kinds of
options.8 -1 OPTIONS VOCaBularY
An option is one example of a derivative security, a security that derives its value from another asset.^
An option fits this description because its value depends on the price of the underlying shares that
the option holder can buy or sell. The asset from which a derivative security obtains its value is
called the underlying asset. A call option grants the right to purchase a share at a fixed price, on or
before a certain date. The price at which a call option allows an investor to purchase the underlying
share is called the strike price or the exercise price. Because the option holder can buy the underlying
share at a fixed price, the more the market price of the share increases, the greater the value of the
call option.LO8.1