CP

(National Geographic (Little) Kids) #1
stock price is $28 when the option expires, your net gain would be $0: you gain $28 
$20 $8 when you exercise the option, but your original investment was $8. Now
suppose the stock price is either $30 or $20 at expiration. If it’s $30, your net gain is
$10 $8 $2. If it’s $20, the stock is out-of-the-money, and your net loss is the $8
cost of your investment. Now suppose the stock price is either $50 or $5. If it’s $50,
your net gain is $30 $8 $22; if $5, your net loss is still your $8 initial investment.
As this example shows, the payoffs from the option aren’t symmetric. The most you
can lose is $8, and this happens whether the stock price at expiration is $20, $10, or
even $1. On the other hand, every dollar of stock price above $20 yields an extra dol-
lar of payoff from the option, and every dollar above $28 is a dollar of net profit.
In addition to the stock price and the exercise price, the price of an option depends
on three other factors: (1) the option’s term to maturity, (2) the variability of the stock

Financial Options 627

FIGURE 17-1 Space Technology Inc.: Option Price and Exercise Value

Exercise Value Market Price Premium
Price of Stock Strike Price of Option of Option (4) (3)
(1) (2) MAX[(1) (2), 0] (3) (4) (5)
$10.00 $20.00 $ 0.00 $ 2.00 $2.00
20.00 20.00 0.00 8.00 8.00
21.00 20.00 1.00 8.75 7.75
22.00 20.00 2.00 9.50 7.50
30.00 20.00 10.00 16.00 6.00
40.00 20.00 20.00 24.50 4.50
50.00 20.00 30.00 33.50 3.50
73.00 20.00 53.00 54.50 1.50
98.00 20.00 78.00 79.00 1.00

20 40 60 80 100

Option Price and
Exercise Value
($)

Market Price
of Option

80

60

40

20

0

–20

Exercise Value
of Option
Premium

Price of Stock ($)

622 Option Pricing with Applications to Real Options
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