Introduction to Corporate Finance

8: Options

Think carefully about what this means. An investor who wants to construct a position with a minimum

payoff of $75, plus the potential for a higher payoff if the share price rises, has two alternatives. He can

either purchase a risk-free bond with a face value of $75, and a call option with X = $75, or can purchase

FIGure 8.6 PAYOFF ON PORTFOLIO OF ONE BOND (FV = $75) AND ONE CALL (X = $75)

The diagram illustrates the payoff of a portfolio containing a call option (upper-left) and a risk-free bond (upper-right). In the bottom graph, we see that
the bond ensures that the portfolio’s payoff will never be less than $75. However, if the underlying share price is greater than $75 on the expiration
date, then the portfolio’s payoff will be greater than $75 because both the bond and the call option will have a positive payoff.

Share price on expiration ($)

0 25 50 75 100 125 150

25

75

50

100

0

Call payoff ($)

25

75

50

100

0

Share price on expiration date ($)

Bond payoff ($)

0 25 50 75 100 125 150

25

75

125

50

0

0 50 75 100 150

Share price on expiration date ($75)

Portfolio payoff ($)

100

25 125