OPTIONS IN CORPORATE FINANCE FINA 763 Spring 2005

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1 OPTIONS IN CORPORATE FINANCE FINA 763 Spring 2005 Dr. William T. Moore Phone: (office) Office: BA (home) Office Hours: Open Objective This course is designed to prepare you to employ options that arise in business finance. Options may take the form of explicit call and put contracts such as stock options and currency options useful in managing risk. They may come in subtler forms as warrants, rights and convertible securities. Or they may be hidden as implicit options in otherwise ordinary capital budgeting proposals. You will learn state-of-the-art methods for assessing the economic values of all these kinds of options. Prerequisites You need to have completed an introductory graduate finance course such as DMSB 715. No formal math or statistics courses beyond the prerequisites for DMSB 715 are required. However, the course is technical and you should not undertake it if you consider yourself weak in math. Grading Plan on a final exam weighted 80 percent each. In addition, you will have periodic assignments and projects that will represent 20 percent of the grade. Books and Other Materials The required book for the course is Real Options and Option-Embedded Securities, published by John Wiley & Sons, During the course you will also be given supplemental material such as cases and journal articles. An errata sheet is posted on the course web site. Web Site From time to time, some items of interest will be placed on the course web site. The URL is then click on FINA 763. Course Outline An annotated course outline begins on the next page. Please read this soon. It will give you some idea of where we are about to go...

2 2 OPTIONS IN CORPORATE FINANCE I. INTRODUCTION A. Options and Other Derivatives In this section, derivative securities are introduced, and it will be shown that options represent a special class of derivatives. The notion of a derivative is very general; any security whose value derives from another. We will begin by contrasting options, forward contracts and futures contracts, all of which are derivative securities. Then we will see that derivatives, and in particular, options, are pervasive throughout corporate finance. B. Options Markets We shall examine in-depth the markets for options, including simple put and call options on common stocks such as those traded on the Chicago Board Options Exchange, puts and calls on foreign currencies (traded on the Philadelphia Stock Exchange and AMEX), convertible securities, warrants and rights. II. SIMPLE OPTIONS A. How are Options used in Portfolios? Various portfolio strategies using call and put options can be constructed in order to exploit investors' expectations of future asset prices. These strategies include straddles, spreads, covered calls and puts, straps, strangles, and riskless hedges. B. What are Options Worth? A variety of factors influence option value; i.e., asset volatility, interest rates, exercise price, maturity, etc. We will see how arbitrage establishes bounds on option values, and we will demonstrate the important put-call parity relationship that describes the exact link between put values and call values. C. The Black-Scholes-Merton Model In the 1970s, a breakthrough in economic science cleared the way for rapid growth of the derivatives industry, with global market value now approaching $70 trillion. That breakthrough was a mathematical model that employs five parameters to price call and put options, and was the work of Black and Scholes (1973) and Merton (1973). We will sketch the derivation of the model in nontechnical terms to provide an intellectual basis for understanding option valuation theory. We will then demonstrate computation of call and put prices using the model.

3 3 D. How Does the Model Work? In this section, we explore the ingredients of call and put option values. This should result in an understanding of the effects on call and put prices of changes in various parameters including interest rates, volatility, time to expiration, and underlying asset values. E. Dividend Adjustments and Currency Options An adjustment to accommodate constant dividends will be explained and we will demonstrate computations of option prices using the dividend adjustment. The dividend adjustment can be adapted to model the values of stock index options. This will enable a discussion of portfolio insurance. We shall then explain how the dividend adjustment can be modified to value call and put options on foreign currencies. III. VALUING CORPORATE LIABILITIES A. Introduction We will explain natural extensions of the option pricing framework to valuing corporate securities, including valuing call provisions and conversion rights. This will take us to modern methods of valuing options and senior securities with embedded options. Practitioners now use methods known as binomial and quadranary trees to value these instruments, and we shall apply this method. B. Why Do Firms Issue Warrants and Convertibles? We begin with some definitions, then discuss motives for issuance; i.e., debt sweeteners, delayed equity financing, and resolution of conflict between stockholders and bondholders. Our discussion will include the scientific evidence of effects of issuance and redemption of convertibles and warrants on firm value. C. What are Warrants Worth? We first identify features of warrants and rights that require special treatment in valuation. We then survey the scientific findings on how well the theoretical models work in describing actual prices. D. What are Convertibles Worth? We describe typical features of contracts for convertible bonds and convertible preferred stocks such as deferred callability and time-varying call prices and conversion terms, then apply state-of-the-art methods in valuing convertible securities.

4 4 IV. REAL OPTIONS A. Introduction Options arise in investments in real assets such as factories and machinery. Such a capital project may represent a series of future cash flows that, unto themselves, do not make the project very appealing (negative net present value). But when options that arise due to the nature of the project are identified and valued, the project may be seen to be economically valuable. B. Investment Timing In some cases, the firm may find it advantageous to defer investing until more is known about the future, or until other developments have taken place. The option to delay is potentially quite valuable. We may also use what we know about option valuation to determine how long a project should be delayed. C. Investment Expansion Opportunities Projects may represent valuable follow-on opportunities that represent call options. For example, a research and development project may be viewed as a call option on a commercial-scale investment. We will learn how to identify and value such options and this will lead us into compound options; i.e., options on options. D. Investment Reversal Opportunities In traditional analysis, we presume of project cash flows will be generated until the project is terminated at a predetermined time. However, the option to abandon the project early, or to scale back operations, also has value. Abandonment may be viewed as a put option and valued accordingly. IV. RISK MANAGEMENT A. Operating Risk The firm s operating risk can be managed using a variety of derivatives including options on commodity futures contracts. We will see how these may be tailored to meet the firm s specific needs.

5 5 B. Financial Risk The firm s financial risk may also be managed with a variety of derivative products including caps, floors and collars. We will explore how these products are designed, valued and employed strategically. C. Second-Generation Options The last several years have seen the development of a host of new or exotic options to meet special needs of firms and investors. Most of these products are so specialized that they are not traded on organized exchanges. Instead they are marketed and traded by investment banks on behalf of their clients.

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