Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

(^832) 24. Option Valuation © The McGraw−Hill
Companies, 2002

CHAPTER

24

Option Valuation

On October 1, 2001,the closing stock prices for American Electric Power,

Automatic Data, and Anadarko Petroleum were $43.84, $46.95, and $47.45,

respectively. Each company had a call option trading on the Chicago Board

Options Exchange with a $50 strike price and an expiration date of November

16, 47 days away. You might expect that the prices on these call options would

be similar, but they weren’t. The American Electric Power options sold for $0.20,

Automatic Data options traded at $1.40, and Anadarko Petroleum options were

$2.40. Why would options on these three similarly priced stocks be priced so

different when the strike prices and time to expiration are exactly the same? If

you go back to our earlier chapter on options, the volatility of the underlying

stock is an important determinant of an option’s value, and, in fact, these three

stocks have very different volatilities. In this chapter, we will explore this issue—

and many others—in much greater depth using the Nobel prize–winning Black-

Scholes Option Pricing Model.

n an earlier chapter, we explored the basics of options, but we didn’t discuss how to

value them in much detail. Our goal in this chapter is to take this next step and exam-

ine how to actually estimate what an option is worth. To do this, we will explore

two very famous results, the put-call parity condition and the Black-Scholes Option

Pricing Model.

An understanding of option valuation lets us illustrate and explore some very impor-

tant ideas in corporate finance. For example, we will show why certain types of merg-

ers are a bad idea. We will also examine some conflicts between bondholder and

stockholder interests. We will even provide some examples under which companies

have an incentive to take negative NPV projects. In each case, option-related effects un-

derlie the issue.

PUT-CALL PARITY

From our earlier discussions, recall that the purchaser of a call option pays for the right,

but not the obligation, to buy an asset for a fixed time at a fixed price. The purchaser of

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24.1

The Options Industry

Council has a web page

featuring a lot of

educational materials:

http://www.888options.com.