Options

Definition of Options

The field of finance utilizes a variety of instruments, one of which is the 'option'. Within this context, options take on a slightly different meaning and can be a bit more complex.

Options Definition Within a Business Context

Within a business or corporate finance context, options are often related to securities and compensation. For instance, companies may provide their employees with stock options as part of their compensation package.

How Options Work in Corporate Finance

Options in corporate finance involve two main parties: the buyer (or holder) and the seller (or writer). Upon signing the contract, the buyer acquires the right, but not obligation, to buy (call option) or sell (put option) the underlying asset. The seller, on the other hand, assumes the obligation to fulfill the transaction if the buyer decides to exercise their right.

Types of Options

• Call options: These give the holder the right to buy the underlying asset. They might buy these if they believe the asset price will increase.
• Put options: These give the holder the right to sell the underlying asset. They are often bought if the asset price is expected to decrease.
• Employee Stock Options (ESOs): These are call options granted by a company to its employees as a form of incentive or compensation. ESOs can hold significance in corporate financial planning.
• Exotic options: These are complex derivatives with features beyond standard American or European options. Their unique structure is often customized to fit the specific needs of the investor.

Call and Put Options Difference

Remember, the key difference between these two types of options comes down to the transaction they offer the right to make. In both cases, the buyer of the option hopes that the market price of the underlying asset will move in a certain direction: upwards for the call option and downwards for the put option.

Market Value of Options Within Corporate Finance

At their core, options are contracts that carry a market value. This market value, also known as the option's premium, represents the price an investor pays to acquire the right (but not the obligation) granted by the option. It's crucial to understand that the market value of options is primarily shaped by a variety of factors. The effect of these factors can be captured mathematically with the help of a few prominent pricing models, such as the Black-Scholes model.

Factors Affecting the Market Value of Options

The price of an option can be influenced by numerous variables, with each reflecting differing aspects of the underlying financial environment. These factors include, among others, the price of the underlying asset, volatility, time to expiry, strike price and the risk-free interest rate. Let's take a more systematic look at each of these factors and discuss how they potentially impact an option's market value.

Price of the Underlying Asset

The underlying asset's current price is a primary driver of an option's market value. For instance, as the price of the underlying asset increases, a call option (which gives the holder the right to buy at a specified price) becomes more valuable as it allows buying the asset below its market price. Conversely, the value of a put option (the right to sell at a specified price) would decline as the market price rises.

Volatility

Volatility refers to the degree of variation observed in the price of a financial instrument over time. It's a measure of uncertainty or risk, and its effect on the market value of an option can be significant. For both call and put options, the higher the expected volatility, the greater the option's market value. Increased volatility means a greater range of potential price movements, thus increasing the likelihood that the option will be in-the-money at expiry.

Time to Expiry

The time remaining until the option's expiration date, known as time to expiry, also impacts its market value. Typically, the longer the time to expiration, the greater the option's value. This is because with more time, there's a higher likelihood of the price of the underlying asset moving in a direction that benefits the holder of the option.

Strike Price

The strike price is the price at which the option holder can buy (for a call option) or sell (for a put option) the underlying asset. As a general rule: the lower the strike price in relation to the market price for a call option, the higher the option's value. Conversely, for a put option, a higher strike price compared to the market price leads to a higher option value.

Risk-Free Interest Rate

The risk-free interest rate represents the interest an investor can earn by investing in a risk-free security, typically a government bond. The risk-free rate has an effect on the market value of an option, particularly when considering the time value of money. With all other factors held constant, the higher the risk-free interest rate, the more valuable call options become, while the value of put options decreases.

Factors Influencing the Market Value of Options

The table above summarises the relationships between different factors and their impact on the market value of call and put options. '+' symbol indicates a direct relationship (if the factor increases, option's value increases), and '-' indicates an inverse relationship (if the factor increases, option's value decreases)

Comparing Options and Futures

In the world of Corporate Finance, both options and futures serve as financial contracts that investors use to make strategic business decisions. However, the two have distinguishing characteristics and their understanding can play a vital role in designing a successful investment strategy.

Options vs Futures: The Core Differences

While both options and futures contracts provide investors with the right to buy or sell an asset at a specific price, they differ in their obligations and potential gains or losses. An understanding of these differences is fundamental to utilizing them effectively in corporate finance.

Obligation vs Right

The most significant difference between an option and a future lies in the obligation it imposes on its stakeholders. A futures contract obligates the holder to buy or sell the asset at the specified price when the contract expires, regardless of the market price at that time. In contrast, the holder of an option has the right, but not the obligation, to buy or sell the asset at the predetermined price.

Potential Gains and Losses

Another significant point of variation between options and futures is the potential gains and losses they carry. Futures have unlimited potential for profit or loss. If the market price moves in favor of the position, the holder stands to make unrestricted profit. Conversely, if the market price moves against the position, the holder may face substantial loss.

An option limits the potential loss to the premium paid for the option. For example, if the holder of a call option chooses not to exercise because the market price of the asset falls below the strike price, the loss is limited to the premium paid for the option.

Flexibility vs Rigidity

Options provide a greater degree of flexibility than futures. With options, the investor has the choice to exercise the right or let it expire, based on market conditions. Consequently, options allow for a wide range of strategic uses including hedging, income generation, leverage, and speculation.

Futures, on the other hand, offer less flexibility, since they obligate the investor to fulfill the contract at expiration - leaving them exposed to potentially large losses if the market does not move in the predicted direction.

Payment Structure

The payment structure of futures and options also follow different schedules. For futures contracts, investors have to deposit an initial margin and maintain a maintenance margin, and might face daily settlement of gains or losses due to variations in the asset's price.

Options work a bit differently. As already mentioned, the investor pays a premium on acquisition. This is the maximum risk faced in holding the option. Thereafter, the only other cash flow is when the option is exercised.

Comparison of Options and Futures

This table provides a summary of the key distinctions between options and futures, providing a concise reference to understand their core differences.

Practical Examples of Call and Put Options

Options play a crucial role in the financial strategy of businesses, aiding in risk management and providing potential for profitable investments. Understanding the practical application of call and put options in real-world businesses can provide insightful knowledge. Let's delve into some examples and analyse these financial instruments' implementation in depth.

Call and Put Options Examples in Real-World Businesses

Within the realm of businesses, both call and put options find a gamut of uses. They offer opportunities for companies to both hedge against potential risks and speculate on potential gains. By purchasing the correct option contract, businesses can ensure a level of security over their investments and operations.

Example 1: Hedging with Put Options

By doing so, the business has ensured that they can sell the raw material at the strike price in six months. If the price does rise, the business can buy the raw material at the market price and simultaneously exercise the put option, effectively obtaining the raw materials at the original price. This hedge protects them against upward price movements.

Example 2: Speculating with Call Options

This provides the retail investor the right to buy 100 shares at the strike price anytime within the next four months. If their prediction proves correct and the price of the shares increases well above the strike price, the investor can exercise the option, buying the shares at the strike price and potentially selling them at the higher market price for a profit.

Analysis of Call and Put Options Examples

In these examples, the application of options comes across clearly. A business uses a put option to hedge against the risk of price increases in raw materials – a form of insurance, paid for by the option premium. Here, the most important aspect is the assurance of cost stability for future operations, even if it comes at the expense of the upfront premium.

Conversely, the retail investor uses a call option to speculate on potential increases in a stock's price, aiming to make a profit. They take a potential risk – the loss of the premium if stock prices do not rise as expected – for a potentially large payoff if things go according to plan. The emphasis here is more on potential profit rather than the mitigation of risk.

In both instances, the risk undertaken is the loss of the option premium, demonstrating the trade-off businesses and investors make when working with options. The detailed analysis of these real-world examples shed light on the strategic considerations that go into utilising options in the financial world.

In conclusion, options offer a robust framework within which businesses and investors can strategize their financial plans, whether for hedging against potential risks or for speculative endeavours.