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Corporate Finance

Corporate Finance ­FIN 622
Lesson 42
How options work?
Exercising the option
Calculating gains on options
Currency options
Hedging with currency options
How Options Work?
Options are also used to reduce the risk of unfavorable price movements in stocks or share, or any
commodity. In other words, the investor is trying to fix the price of the commodity or stock by trading
now. Therefore, the first objective of using options is to eliminate the risk of adverse price movement.
However, there may be some gain on this transaction with some chances of loss as well.
In order to understand how option actually works, we take up the following example and see what factors
we need to consider when we are going to exercise the option:
An investor buys 20 options on shares of xyz ltd at a price of Rs 500 (per share). Each option consists of
100 shares and premium paid is Rs. 5/- per share. What will happen if, at the expiry of option, the share
price is?
i) 516 or
ii) 490?
Looking at the example, the investor is trying to hedge the adverse price movement of that particular stock
in near future. He may not have the funds right now and expects to receive the same in near future so he is
interest in "arresting" the price now by buying an option. However, this is going to cost.
You can see that there is Rs. 5/per share as option cost. If the investor does not exercise the option, he
must bear this in mind that "this cost" will represent the loss. In options, the loss is normally the amount
that has been paid as option cost.
Now the question is "under what circumstances" the investor will exercise the option. The investor and the
option seller have agreed over a price of Rs 500/ per share meaning that the investor will buy the agreed
number of shares from the option seller for this per share amount, regardless of what per share cost actually
prevail in the market on that date if date is falling within the terms of agreement.
Decision Rule:
If on or before the expiry date, the price of share is greater than the agreed rate of Rs. 500 per share, then
the investor will exercise it right to buy stipulated number of shares from the option seller. Nevertheless,
the cost factor should also be considered by deducting the cost per share from the prevalent price of the
share on the exercising date.
Calculations of gain and loss:
Now if the share price, per first scenario, is Rs. 516, which is significantly above the agreed price of Rs. 500
per share, the option should be exercised. This is because at present this particular stock is being traded at
Rs. 516 per share whereas the investor will get the same for Rs. 500 per share ­ the agreed price. This
results in a gain of Rs. 16 per share and the total gain would be Rs 16 per share multiplied by total number
of shares. Remember this will be gross gain and we need to subtract the option cost of Rs 5 per share to
reach at net gain.
Now consider the other scenario. If the market price of share in question is Rs. 490 per share, the question
will be "is there any benefit in exercising the option?"
No is the answer. Why? Look the market price of that stock now is Rs. 490 per share and that means that
investor can buy it cheap from the market instead of buying form the option seller for Rs. 500 per share. In
this situation, the investor is not going to exercise it and the cost paid as option fee represents the loss to
the investor and gain to the option seller.
In both the situations we can easily sum up that loss of one party is the gain of other party. This is called
zero sum game. Take the second scenario the investor is confront with the loss in terms of cost of option.
The total loss is the cost of Rs. 5 per share multiplied by total number of shares (Rs. 10,000), which is the
gain of the option seller.
Corporate Finance ­FIN 622
Currency Options:
Currency option is a contract like equity options that we have covered in previous section. This is a
contract, which confers right to the buyer to buy or sell (but not obligation) a fixed amount of underlying
currency at a fixed price (strike price) on a fixed date (expiry).
Amount of underlying currency is governed by the contract size as determined in each currency. A buyer of
a call option has a right but not the obligation to buy the underlying currency. A buyer of a put option has a
right but not the obligation to sell the underlying currency. Premium is charged by option writer from
option holder.
Hedging with Currency Option:
To construct a hedge with currency option, one needs to consider the following:
The extent of exposure and the currency involved ­ future receipt and payment to be determined.
Consider the hedging tool ­ a call or put option will serve the purpose.
Calculate the most suitable strike price out of several available.
Option will be only exercised if it is in the money and buy or sell the currency at the strike price.
Alternatively, let the option lapse if it is out of money. Progress
Interest Rate Options:
An investment tool whose payoff depends on the future level of interest rates. Interest rate options are both
exchange traded and over-the-counter instruments.
An interest rate option carries a notional amount of principal, which means that it is not the actual amount
to be taken out from a account. It is used to calculate the terminal gain or loss calculation. This aspect of
interest rate options is similar to FRAs and short-term interest rate futures. Such options are either over the
counter or exchange traded. We shall discuss exchange-traded options only.
If the option is exercised, it is cash settled. The strike rate for the option is compared with an agreed
benchmark rate of interest. Benchmark rate may be KIBOR. (Karachi Inter Bank Offered Rate)
For example, a firm buys a borrowers' option in February to borrow a notional amount of Rs. 5 million on
May 31 for three months at interest rate of 5% per annum. A premium is charged for the option.
At the expiry of three months, the benchmark rate may be higher than the strike rate of 5%. If so, the
borrower's option is in the money and will be exercised. However, the option holder does not receive a
three-month loan at 5%. Instead, it will borrow the money it needs at the prevailing market rate. The option
seller must make a cash payment to the option holder for the difference between the benchmark and strike
rate at the expiry date.
And if at expiry, the three-month benchmark rate is lower than the strike rate of 5% then the borrower's
option is out of the money and the option will not be exercised. The company will borrow the money it
needs in the market at the prevailing rate.
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk