Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
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The option is worthless as long as the strike price exceeds the exercise price by an amount equal to the
premium paid. The payoff can be plotted on a diagram as shown:

Profit

Loss Break Even

Stock price S

–C

The maximum that an option holder loses is the premium paid whereas the upside potential is unlimited. The
value of the option increases one-to-one for any increase in price above the break-even price. Since each
option is for 100 shares, the strike price, exercise price and the premium have to be multiplied by 100 to
arrive at the aggregate payoff. If the holder of the option decides to exercise the option he should pay Rs 180
× 100 (i.e., exercise price × 100 shares). Those options worth exercising are called in-the-money, and those
that are not are considered out-of-the-money. The payoff from the perspective of a seller is as shown:

+C

Payoff Price of the underlying asset

Note that the seller (writer) of the call option gets the premium as long as the strike price is lower than the
exercise price. While the upside is fixed, the downside is unlimited. Also note that the payoffs are mirror
images—what the buyer gains the seller loses and vice versa. That is, they sum to zero (zero sum game). The
value of a put option on the expiration date = P = maximum (0, X-S). The payoff to a long put option position
is as shown:

Payoff Price of the underlying asset

Note that the buyer of the put option makes money if the ending spot price of the underlying asset is lower
than the exercise price. Likewise, the payoff to the writer of a put option is as shown: