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.