FINA 410 Study Guide - Final Guide: Valuation Of Options, Dividend Discount Model, Dividend Yield
11 Jan 2017
School
Department
Course
Professor
FINA%410:%Investment%Analysis%
Fall%2016
Chapter(5:"Option"Pricing"Theory"and"Models!
Options%are%assets%with%2%special%characteristics:%
• The%asset%derive&their&value%for%the%value%of%other&assets%
• The%cash&flows%on%the%assets%are%contingent&on&the&occurrence&of&specific&events%
The%PV%of%the%expected%CF%will%understate%their%true%value.%%
!"#$%#&'(&')*$'+&),$%$+-&
An%option%provides%the%holder%with%the&right&to&buy&or&sell&a&specific&quantity&of&an&underlying&asset&at&a&
fixed&price&(strike&price/exercise&price)&at&or&before&the&expiration&date&of&the&option.%Since%a%right%isn’t%an%
obligation,%the%holder%can%choose&whether&to&exercise&there&right&or¬%and%allow%the%option%to%expire.%2%
types%of%options:%call&options%and%put&options.%Payoff%diagram%illustrates%the%cash%payoff%on%an%option%at%
expiration.%%
%.//&0&)12&'3245678&9:7;<432456&.6=&).>5??&94.@<.A7&
A!call!option%gives%the%buyer%of%the%option%the%right%to%buy%the%underlying%asset%at%the%strike%price%or%the%
exercise%price%at%any%time%prior%to%the%expiration%date%of%the%option.%The%buyer%pays%a%price%for%this%right.%
If% at% the% expiration% the% value% of% the% asset% is% less% than% the% strike% price,% the% option% is% not% exercised% and%
expires%worthless.%If%it%is%greater,%the%option%is%exercised:%the%buyer%of%the% option% buys%the%stock%at%the%
exercise%price.%
%
Value%underlying%asset%<%Strike%price%
• Net%payoff%is%negative%&%equal%to%the%price%paid%for%the%call%
Value%underlying%asset%>%Strike%price%
• Gross%payoff%=%Value%Underlying%Asset%–%Strike%Price%
• Net%payoff%=%Gross%payoff%–%Price%of%the%call%
%%
A! put! option% gives% the% buyer% the% option% the% right% to% sell% the% underlying% asset% at% a% fixed% price% (strike&
price/exercise&price)%at%any%time%prior%to%the%expiration%date%of%the%option.%The%buyer%pays%a%price%for%this%
right.%If%the%price%of%the%underlying%asset%is%greater%than%the%strike%price,%the%option%will%not%be%exercised%
and%will%expire%worthless.%But%if%the%price%of%the%underlying%asset%is%less%than%the%strike%price,%the%owner%of%
the% put% option% will% exercise% the% option% and% sell% the% stock% at% the% strike% price,% claiming% the% difference%
between%the%strike%price%and%the%market%value%as%gross%profit.%Net%profit%=%Gross%profit%–%Initial%cost%paid.%
%
For%a%put%option:%
Value%underlying%asset%>%Strike%price%
• Net%payoff%is%negative%&%equal%to%the%price%paid%for%the%put%
Value%underlying%asset%<%Strike%price%
• Gross%payoff%=%Strike%Price%-%Value%Underlying%Asset%%
• Net%payoff%=%Gross%payoff%–%Price%of%the%put%
9B*B,C$+"+*#&'(&')*$'+&D"EFB&
The% value% of% an% option% is% determined% by% 6% variables% relating% to% the% underlying% asset% and% financial%
markets:%
1) Current&value&of&the&underlying&asset:%Since%the%value%of%an%option%derives%from%an%underlying%asset,%
changes%in%value%of%this%underlying%asset%affect%the%value%of%the%option.%
• For%a%call,%an%increase%in%the%underlying%asset%would%crease%its%value%%
• For%a%put,%an%increase%in%the%underlying%asset%would%decrease%its%value%%
%
%
2) Variance&in&value&of&the&underlying&asset:%The%higher%the%variance%in%the%value%of%the%underlying%asset,%
the%greater%the%value%of%the%option%(put%&%call).%Since%buyers%of%options%can%never%lose%more%than%the%
price%they%pay%for%the%option.%%
%
%
3) Dividends&paid&on&the&underlying&asset:%The%value%of%the%underlying%asset%is%expected%to%decrease%if%
dividend%payments%are%made%on%the%asset%during%the%life%of%the%option.%
• The%value%of%a%call%is%a%decreasing%function%of%the%size%of%the%expected%dividends%
• The%value%of%a%put%is%a%increasing%function%of%expected%dividend%payments%
%
%
4) Strike&price&of&the&option:%Characteristic%used%to%describe%an%option.%
• Calls,%where%the%holder%acquires%the%right%to%buy%at%a%fixed%price,%the%value%of%the%call%will%decline%as%
the%strike%price%increases%
• Puts,%where%the%holder%has%a%right%to%sell%at%a%fixed%price,%the%value%will%increase%as%the%strike%price%
increases%
%
%
5) Time&to&expiration&of&the&option:%Options%(puts%and%calls)%are%more%valuable%the%greater%the%time%to%
expiration.%Since%it%provides%more%time%for%the%value%of%the%underlying%asset%to%move,%increasing%the%
value%of%both%types%of%options.%
• Call,%where%the%buyer%has%the%right%to%pay%a%fixed%price%at%the%expiration,%the%PV%of%this%fixed%price%
decreases%as%the%life%of%the%option%increases,%increasing%the%value%of%the%call%%
%
%
6) Riskless& interest& rates& corresponding& to& the& life& of& the& option:% Since% the% price% of% the% option% is% paid%
upfront,%there%is%an%opportunity%cost.%This%cost%depends%on%the%level%of%interest%rates%and%the%time%to%
expiration%of%the%option.%The%riskless%interest%rate%also%enters%into%the%valuation%of%the%options%when%
the%PV%of%the%exercise%price%is%calculated%since%the%exercise%price%doesn’t%have%to%be%paid%(received)%
until%the%expiration%of%the%call%(put).%%
• Value%of%the%call%increases%with%the%increase%in%the%interest%rates%
• Value%of%the%put%decreases%as%the%interest%rate%increases%
%
%
%
!
Effect!on!
Factor!
Call!Value!
Put!Value!
Increase%in%underlying%asset’s%value%
Increases%
Decreases%
Increase%in%variance%of%underlying%asset%
Increases%
Increases%
Increase%in%strike%price%
Decreases%
Increases%
Increase%in%dividends%paid%
Decreases%
Increases%
Increase%in%time%to%expiration%
Increases%
Increases%
Increase%in%interest%rates%
Increases%
Decreases%
