Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition
VIII. Topics in Corporate
Finance
- Option Valuation © The McGraw−Hill^833
Companies, 2002
a put option pays for the right to sell an asset for a fixed time at a fixed price. The fixed
price is called the exerciseor strikeprice.
Protective Puts
Consider the following investment strategy. Today, you buy one share of Microsoft for
$110. At the same time, you also buy one put option with a $105 strike price. The put
option has a life of one year, and the premium is $5. Your total investment is $115, and
your plan is to hold this investment for one year and then sell out.^1
What have you accomplished here? To answer, we created Table 24.1, which shows
your gains and losses one year from now for different stock prices. In the table, notice
that the worst thing that ever happens to you is that the value of your investment falls to
$105. The reason is that if Microsoft’s stock price is below $105 per share one year from
now, you will exercise your put option and sell your stock for the strike price of $105,
so that is the least you can possibly receive.
Thus, by purchasing the put option, you have limited your “downside” risk to a max-
imum potential loss of $10 (i.e., $115 $105). This particular strategy of buying a
stock and also buying a put on the stock is called a protective put strategy because it
protects you against losses beyond a certain point. Notice that the put option acts as a
kind of insurance policy that pays off in the event that an asset you own (the stock) de-
clines in value.
In our example, we picked a strike price of $105. You could have picked a higher
strike price and limited your downside risk to even less. Of course, a higher strike price
would mean that you would have to pay more for the put option, so there is a trade-off
between the amount of protection and the cost of that protection.
An Alternative Strategy
Now consider a different strategy. You take your $115 and purchase a one-year callop-
tion on Microsoft with a strike price of $105. The premium is $15. That leaves you with
$100, which you decide to invest in a riskless asset such as a T-bill. The risk-free rate is
5 percent.
808 PART EIGHT Topics in Corporate Finance
(^1) Of course, in reality, you can’t buy an option on just one share, so you would need to buy 100 shares of
Microsoft and one put contract at a minimum to actually implement this strategy. We’re really just
explaining the calculations on a per-share basis.
TABLE 24.1
Gains and Losses in
One Year.
Original investment:
purchase 1 share at
$110 plus a one-year
put option with a strike
price of $105 for $5.
Total cost is $115.
Stock Price Value of Put Option Combined Total Gain or Loss
in One Year (Strike Price $105) Value (Combined Value Less $115)
$125 $ 0 $125 $10
120 0 120 5
115 0 115 0
110 0 105 5
105 0 105 10
100 5 105 10
95 10 105 10
80 15 105 10
For a free site that
promises to allow you to
“paper trade” options,
visit paper-trade-
options.com.
protective put
The purchase of stock
and a put option on the
stock to limit the
downside risk
associated with the
stock.