Chapter 23

Options are very useful financial products to analyse complex corporate finance problems. You will soon see that the number of ways in which they can be used are numerous! That is why this chapter is so important.

An option is a contract between two sides, under which one side gives the other the right (but not the obligation) to buy from them (a call option) or sell to them (a put option) an asset, in exchange for the payment of a premium. This asset will be bought (or sold) at a predetermined price called the strike price, during a period of time (the exercise period for US-style options) or at a precise date (the exercise date for European-style options). The basis of an option is the remuneration of risk. The option cannot exist in a risk-free environment and it thrives on risk.

The value of an option (call or put) can be broken down into an intrinsic value and a time value. The intrinsic value is the difference between the price of the underlying asset and the option’s strike price. It can only be zero or positive. The time value is the premium on the intrinsic value, which remunerates the time left until expiry of the option.

There are six criteria for determining the value of an option:

  • the price of the underlying asset;

  • the strike price;

  • the volatility of the underlying asset;

  • the option’s maturity;

  • the risk-free rate; and, if applicable,

  • the dividend or coupon if the underlying asset is a share or a bond that pays one or the other during the life of the option.

Models have been developed for valuing options, the main ones being the Black–Scholes and binomial models. They have been adapted over time to make them less restrictive and capable of factoring in specific features.