Introduction to Corporate Finance

8: Options

Pause a moment to take an inventory of the information that is required to value the Mototronics put

option. To calculate the put value, we had to know the following facts:

■ the strike price of the option, $30

■ the current price of the underlying shares, $28

■ the amount of time remaining before the option expires, one year

■ the risk-free interest rate, 5%

■ the price of the call option, $6.

It turns out that each of these items, except for the last one, is required to value an option, whether

we use put–call parity or an alternative method to determine the option’s price. In the next section,

we provide an intuitive, qualitative explanation of how several of these factors influence option

prices.

5 What would happen if an investor who owned a share of a particular company also bought a put

option with a strike price of $50, and sold a call option with a strike price of $50? Try to draw the

payoff diagram for this portfolio.

6 Is selling a call the same thing as buying a put? Explain why or why not.

7 A major corporation is involved in high-profile anti-competitiveness litigation with the government.

The company’s share price is somewhat depressed due to the uncertainty surrounding the case. If

the company wins, investors expect its share price to shoot up. If it loses, its share price will decline

even more than it already has. If investors expect a resolution to the case in the near future, what

effect do you think that resolution will have on put and call options on the company’s shares? (Hint:

think about Figure 8.3.)

CONCEPT REVIEW QUESTIONS 8-2

8-3 QualIT aTIVe aNalYSIS OF OPTION

PrICeS

Before getting into the rather complex quantitative aspects of pricing options, let’s cultivate the intuition

needed to understand the factors that influence option prices. We begin by taking a look at recent

price quotes for options on Charybdis Machine Company shares. Table 8.2 shows the prices of several

Charybdis option contracts in February 2016.

8-3a FaCTOrS THaT INFlueNCe OPTION ValueS

You should notice a striking pattern here. The prices of both calls and puts rise the longer the time before

expiration. To understand why, think about the call option that expires in March, roughly one month in the

future (are from the date that we gathered the option prices). Currently this option is out of the money

because it grants the right to purchase Charybdis’ shares for $85, but investors can buy Charybdis in

LO8.3

See the concept explained

step by step on the

CourseMate website.

SMarT

CONCEPTS

How are the prices of put

and call options on the same

underlying share related to

each other?

thinking cap

question