Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance(^482) © The McGraw−Hill
Companies, 2002
OPTIONS: THE BASICS
An option is a contract that gives its owner the right to buy or sell some asset at a fixed
price on or before a given date. For example, an option on a building might give the
holder of the option the right to buy the building for $1 million anytime on or before the
Saturday prior to the third Wednesday of January 2010.
Options are a unique type of financial contract because they give the buyer the right,
but not the obligation, to do something. The buyer uses the option only if it is profitable
to do so; otherwise, the option can be thrown away.
There is a special vocabulary associated with options. Here are some important
definitions:
1.Exercising the option. The act of buying or selling the underlying asset via the
option contract is called exercising the option.
2.Strike price, or exercise price. The fixed price specified in the option contract at
which the holder can buy or sell the underlying asset is called the strike priceor
exercise price.The strike price is often called the striking price.
3.Expiration date. An option usually has a limited life. The option is said to expire
at the end of its life. The last day on which the option may be exercised is called the
expiration date.
4.Americanand European options. An American option may be exercised anytime
up to and including the expiration date. A European option may be exercised only
on the expiration date.
Puts and Calls
Options come in two basic types: puts and calls. Acall optiongives the owner the right
to buyan asset at a fixed price during a particular time period. It may help you to re-
member that a call option gives you the right to “call in” an asset.
Aput optionis essentially the opposite of a call option. Instead of giving the holder
the right to buy some asset, it gives the holder the right to sellthat asset for a fixed ex-
ercise price. If you buy a put option, you can force the seller of the option to buy the as-
set from you for a fixed price and thereby “put it to them.”
What about an investor who sellsa call option? The seller receives money up front
and has the obligationto sell the asset at the exercise price if the option holder wants it.
Similarly, an investor who sellsa put option receives cash up front and is then obligated
to buy the asset at the exercise price if the option holder demands it.^1
The asset involved in an option can be anything. The options that are most widely
bought and sold, however, are stock options. These are options to buy and sell shares of
stock. Because these are the best-known types of options, we will study them first. As
we discuss stock options, keep in mind that the general principles apply to options in-
volving any asset, not just shares of stock.
Stock Option Quotations
On April 26, 1973, the Chicago Board Options Exchange (CBOE) opened and began or-
ganized trading in stock options. Put and call options involving stock in some of the
454 PART FIVE Risk and Return
14.1
exercising the option
The act of buying or
selling the underlying
asset via the option
contract.
strike price
The fixed price in the
option contract at which
the holder can buy or sell
the underlying asset.
Also, the exercise price
or striking price.
expiration date
The last day on which an
option may be exercised.
American option
An option that may be
exercised at any time
until its expiration date.
European option
An option that may only
be exercised on the
expiration date.
call option
The right to buy an asset
at a fixed price during a
particular period of time.
put option
The right to sell an asset
at a fixed price during a
particular period of time.
The opposite of a call
option.^1 An investor who sells an option is often said to have “written” the option.