PART 5
Options, International Finance, and Risk Management
In the last three decades, no part of finance has witnessed as much innovation or explosive growth as the area covered in Part 5. In 1973, two economists published a paper which, for the first time, provided a formula for pricing an exotic financial instrument called an option. Almost immediately, an options exchange opened where traders could buy and sell these instruments. In just a few years, the number of venues trading options and the variety of options available exploded.
Over the same period, countries around the world began lowering trade barriers, resulting in a tremendous increase in exports and imports. Multinational corporations expanded their operations and their brands all over the world. But as a result of their expansion into foreign countries, which required firms to do business in many different currencies, these companies faced exposure to a new set of risks. Fortunately, options and other exotic securities provided just the tools that multinational corporations needed to manage these risks.
Chapter 15 provides an introduction to options. We begin with a simple explanation of option contracts, illustrating how option payoffs depend on, or derive from, the performance of an underlying stock. We explain how traders can use options to take risk or to reduce it, and we show how the price of an option depends on five key factors. Chapter 15 concludes with an introduction to the famous option-pricing model developed way back in 1973.
Chapter 16 deals with the unique financial issues that arise when firms do business in multiple currencies. The chapter starts with an explanation of how different countries establish an exchange rate policy. Next, the chapter illustrates how exchange rates are quoted and how exchange rates are linked across countries. Many factors influence currency values, including differences in inflation rates and interest rates in different countries. Chapter 16 shows how inflation and interest rates affect exchange rates and how smart traders may find profit opportunities when markets are not in equilibrium.
Chapter 17 addresses the issue of risk management. The risks that firms face on a daily basis are not limited to the exchange rate fluctuations discussed in Chapter 16, but include changes in the prices of commodities such as oil and changes in interest rates. Financial markets offer managers a vast array of instruments to help them reduce their firms' exposures to all of these sources of risk. Chapter 17 describes some of these instruments and illustrates how firms use them to reduce or eliminate exposure to certain risks.
Part 1: Introduction
1The Scope of Corporate Finance
2Financial Statement and Cash Flow Analysis
3Present Value
Part 2: Valuation, Risk, and Return
4Valuing Bonds
5Valuing Stocks
6The Trade-off Between Risk and Return
7Risk, Return, and the Capital Asset Pricing Model
Part 3: Capital Budgeting
8Capital Budgeting Process and Techniques
9Cash Flow and Capital Budgeting
10Risk and Capital Budgeting
Part 4: Capital Structure and Dividend Policy
11Raising Long-Term Financing
12Capital Structure
13Dividend Policy
14Entrepreneurial Finance and Venture Capital
Part 5: Options, International Finance, and Risk Management
15Options
16International Financial Management
17Risk Management
Part 6: Financial Planning and Management
18Financial Planning
19Cash Conversion, Inventory, and Receivables Management
20Cash, Payables, and Liquidity Management
Part 7: Special Topics
21Long-Term Debt and Leasing
22Mergers, Acquisitions, and Corporate Control
23Bankruptcy and Financial Distress
Part 1: Introduction
1The Scope of Corporate Finance
2Financial Statement and Cash Flow Analysis
3Present Value
Part 2: Valuation, Risk, and Return
4Valuing Bonds
5Valuing Stocks
6The Trade-off Between Risk and Return
7Risk, Return, and the Capital Asset PricingModel
Part 3: Capital Budgeting
8Capital Budgeting Process and Techniques
9Cash Flow and Capital Budgeting
10Risk and Capital Budgeting
Part 4: Capital Structure and Dividend Policy
11Raising Long-Term Financing
12Capital Structure
13Dividend Policy
14Entrepreneurial Finance and Venture Capital
Part 5: Options, International Finance, and Risk Management
15Options
15.1Options Vocabulary
15.2Option Payoff Diagrams
15.3Qualitative Analysis of Option Prices
15.4Option Pricing Models
15.5Options in Corporate Finance
15.6Summary and Conclusions
16International Financial Management
17Risk Management
Part 6: Financial Planning and Management
18Financial Planning
19Cash Conversion, Inventory, and Receivables Management
20Cash, Payables, and Liquidity Management
Part 7: Special Topics
21Long-Term Debt and Leasing
22Mergers, Acquisitions, and Corporate Control
23Bankruptcy and Financial Distress
Chapter 15
Options
Opening Focus
Cuban Collars Yahoo!
In the late 1990s, newspapers were littered with stories of entrepreneurs who had made and lost huge fortunes throughout the rise and fall of “dot-com” stocks. One such story involved college classmates, Mark Cuban and Todd Wagner, who came up with the idea to broadcast sports events over the Internet so that fans, no matter where they lived, could track their favorite teams. Dubbing their company Broadcast.com, Cuban and Wagner quickly expanded their product offerings beyond sports, capturing media attention with events such as a Victoria’s Secret Web cast and President Clinton’s grand jury testimony. In just a few years, the company’s revenues grew to almost $25 million. However, like most Internet stocks, Broadcast.com was not profitable. In 1998, the company lost $16.4 million, even though it attracted millions of “viewers” to its premier events.
In April 1999, Yahoo! agreed to acquire Broadcast.com for $5.7 billion in a stock swap. The deal’s terms called for an exchange of each Broadcast.com common share for 0.77 Yahoo! shares. At the time, Yahoo! stock was worth nearly $200 per share. But in just one year, the stock market turned sour for Internet stocks. In September 2001, Yahoo! shares began a long slide that bottomed out at about $8. Many Yahoo! executives saw their wealth evaporate, but not Mark Cuban.
Sensing that the market values of Internet stocks had reached their peak, Cuban engaged in a little financial engineering. Cuban purchased put options on Yahoo! shares and simultaneously sold Yahoo! call options. The put options would enable Cuban to sell Yahoo! shares at a fixed price, at any time during the next three years, effectively providing him with an insurance policy against a collapse of Yahoo!’s stock price. To pay for the put options, Cuban sold call options, which would obligate him to sell his Yahoo! shares if the price rose high enough. In essence, Cuban was placing a “collar” around the value of his shares. If Yahoo! stock dropped, Cuban’s put options would allow him to sell his shares at an above-market price. But if Yahoo! stock rose, Cuban would have to part with his shares for less than their full value. The collar allowed Cuban to eliminate downside risk, at the cost of giving up future gains on Yahoo! shares. As it turned out, Cuban’s move may have saved him more than $1 billion. With the cash he obtained as he sold his holdings of Yahoo! stock, Cuban purchased the NBA’s Dallas Mavericks franchise, invested in high-definition TV, and pursued other business opportunities. Though Yahoo! stock rebounded from its all-time low, by early 2004, the shares were only worth about one quarter of their value when Cuban sold out.
Sources: After Hitting It Big on Internet, Cuban Is Scoring in Basketball, The Wall Street Journal, April 22, 2003.
Learning Objectives
After reading this chapter you should be able to:
•Describe the basic features of call and put options;
•Construct payoff diagrams for individual options as well as portfolios of options and other securities;
•Explain qualitatively what factors are important in determining option prices;
•Calculate the price of an option, using the binomial model; and
•List several corporate finance applications of option pricing theory.
A bit of folk wisdom says, “Always keep your options open.” This implies that choices have value. Having the right to do something is better than being obligated to do it. This chapter shows how to apply that intuition to financial instruments called options. In their most basic forms, options allow investors to buy or to sell an asset at a fixed price, for a given period of time. As the opening focus illustrates, having the right to sell shares at a fixed price can be extremely valuable, provided the price of the underlying stock moves in the right direction.
Many commentators see options merely as a form of legalized gambling for the rich. We strongly disagree with that perspective. Options exist because they provide real economic benefits that come in many different forms. First, options provide incentives for managers to take actions that increase their firms’ stock prices, thereby increasing the wealth of shareholders. Abuses may occur when firms award excessive option grants, but we see this as a corporate governance problem, not a problem with options, per se.
Second, a wide variety of options exist, which allow holders the right to buy and to sell many different types of assets, not just shares of stock in a single company. Sometimes, trading the option is more cost effective than trading the underlying asset. For example, trading a stock index option, which grants the right to buy or to sell a portfolio of stocks such as the S&P 500, enables investors to avoid paying all of the transactions costs that would result from trading 500 individual stocks.
Third, firms use options to reduce their exposure to certain types of risk. Firms regularly buy and sell options to shelter their cash flows from movements in exchange rates, interest rates, and commodity prices. In that function, options resemble insurance much more than they resemble gambling.
Smart practices video
Myron Scholes, Stanford University and Chairman of Oak Hill Platinum Partners
“Options markets have grown dramatically
over the last 30 years.”
See the entire interview at
Fourth, options facilitate the creation of innovative trading strategies, like the one adopted by Mark Cuban. If Yahoo! executives insisted on paying for their acquisition of Broadcast.com with Yahoo! stock rather than with cash, Mark Cuban and other Broadcast.com shareholders faced several alternatives. They could hold their Yahoo! shares, but doing so would subject them to the risk of a decline in Yahoo! stock. They could sell their shares, but selling would trigger capital gains taxes and maybe put downward pressure on Yahoo! stock. Alternatively, they could use options to protect their gains and sell their Yahoo! shares at a more leisurely pace.
The growth in options trading and trading in other exotic financial instruments such as futures contracts offers some evidence of our claim that options provide real economic benefits to society. As the Comparative Corporate Finance insert explains, the growth in options markets has been a worldwide phenomenon for roughly the past twenty-five years. In many of the world’s largest economies, trading in stock options exceeds the trading volume in the underlying stocks themselves.
Why does a chapter on options belong in a corporate finance textbook? We offer three answers. First, employees of large and small corporations regularly receive options as part of their compensation. It is valuable for both the employees and the employers to understand the value of this component of pay packages. In early 2004, as this text was going to press, it appeared that the Financial Accounting Standards Board (FASB) would require firms to deduct a charge for employee stock options when calculating net income. Clearly, it is necessary to understand how to determine the value of options to calculate the proper expense for employee stock option grants. Second, firms often raise capital by issuing securities with embedded options. For example, firms can issue debt that is convertible into shares of common stock, at a lower interest rate than ordinary, nonconvertible debt. To evaluate whether the interest savings is worth giving bondholders the opportunity to convert their bonds into shares requires an understanding of option pricing. Third, many capital budgeting projects have characteristics similar to options. The net present value method, discussed in Chapters 8–10, can generate incorrect accept/reject decisions for projects with downstream options. The best way to develop the ability to recognize which real investment projects have embedded options and which ones do not is to become an expert on ordinary financial options.
We begin this chapter with a brief description of the most common types of stock options and their essential characteristics. Next, we turn our attention to portfolios of options, illustrating how options can be used to construct unique trading strategies and gaining insight into how prices of different kinds of options are linked together in the market. The rest of the chapter examines factors that influence option prices, and we introduce a simple, yet powerful, tool for pricing many different kinds of options.
Comparative Corporate Finance
International Derivatives Trading
Since options began trading in the United States in 1973, the growth in options (and other derivatives) trading has been remarkable, and not only in the U.S. In 1978, call options on ten stocks began trading on the London Traded Options Market, and that same year, the European Options Exchange opened in Amsterdam. Today, equity-linked derivatives such as stock options, stock index options, and index futures contracts trade in roughly thirty countries, including most of the largest economies of North America, Europe, and Asia. Even Brazil, which formed its Bolsa de Mercadorias and Futuros exchange in 1985, now ranks among the world’s top ten equity derivative markets, in terms of annual trading volume. Other nations with derivative markets that rank in the top ten include the United States, the United Kingdom, Germany, and France.
In many of these markets, trading in equity derivatives exceeds the volume of trading in the underlying stocks. The figure below shows the volume of trading in equity options and equity futures contracts, each relative to trading in stocks, in thirteen countries. Using the combined trading volume of options and futures contracts, we see that trading in derivatives is greater than trading in the underlying shares in every country except Canada and Sweden.
Source: Francis, Jack C., William W. Toy, and J. Gregg Whittaker, eds. (2000) Handbook of Equity Derivatives (revised edition) New York: John Wiley & Sons, Inc.
15.1Options Vocabulary
An option is one of the three main types of derivative securities, a class of financial instruments that derive their value from other assets.1 An option fits this description because its value depends on the price of the underlying stock that the option holder can buy or sell. The asset from which a derivative security obtains its value is called the underlying asset. A call option grants the right to purchase a share of stock at a fixed price, on or before a certain date. The price at which a call option allows an investor to purchase the underlying share is called the strike price or the exercise price. It is not too hard to see how a call option’s value derives from the value of the underlying stock. For example, if a particular call option has an exercise price of $25, then the holder of the option can purchase one share of underlying stock for $25. If the market price of the stock rises above $25, the call option’s value will increase because it allows the option holder to purchase the stock at a bargain price. On the other hand, if the underlying stock’s price stays below $25, then the call option holder will not exercise the right to buy the stock for $25. Because it is cheaper to buy the stock at the market price than at the exercise price, the call option’s value is low (perhaps even zero).
derivative securities Securities such as options, futures, forwards, and swaps that derive their value from some underlying asset.
underlying asset The asset from which an option or other derivative security derives its value.
call option An option that grants the right to buy an underlying asset at a fixed price.
strike price The price at which an option holder can buy or sell the underlying asset.
exercise price The price at which an option holder can buy or sell the underlying asset.
Call options grant investors the right to purchase a share for a fairly short time period, usually just a few months.2 The point at which this right expires is called the option’s expiration date. An American call option gives holders the right to purchase stock at a fixed price, on or before its expiration date, whereas a European call option grants that right only on the expiration date. If we compare the prices of two options that are identical in every respect, except that one is American and one is European, the price of the American option should be at least as high as the European option because of the American option’s greater flexibility.