BDM - Corporate Finance, Options

PArT
Options 7
THE LAW OF ONE PRICE CONNECTION. Having developed the tools to Chapter 20
make current investment decisions, we turn to settings in which the firm or an investor Financial Options
has the option to make a future investment decision. Â�Chapter 20 introduces financial
options, which give investors the right to buy or sell a security in the future. Financial
Chapter 21
options are an important tool for corporate financial managers seeking to manage or
evaluate risk. Options are an example of a derivative security. In the last 30 years, there Option Valuation
has been enormous growth in the derivative securities markets in general and options
markets in particular. This growth can be traced directly to the discovery of methods Chapter 22
for valuing options, which we derive in Chapter 21 using the Law of One Price. An real Options
important corporate application of option theory is in the area of real investment deci-
sion making. Future investment decisions within the firm are known as real options and
Chapter 22 applies real option theory to corporate decision making.
755
Cha p te r
20 Financial Options
Notat ion IN THIS CHAPTER, WE INTRODUCE THE FINANCIAL OPTION, A

PV present value financial contract between two parties. Since the introduction of publicly traded
options on the Chicago Board Options Exchange (CBOE) in 1973, financial options
Div dividend
have become one of the most important and actively traded financial assets and impor-
C call option price tant tools for corporate financial managers. Many large corporations have operations
P put option price in different parts of the world, so they face exposure to exchange rate risk and other
S stock price types of business risk. To control this risk, they use options as part of their corporate
K strike price risk management practices. In addition, we can think of the capitalization of the firm
itself—that is, its mix of debt and equity—as options on the underlying assets of the
dis discount from face value
firm. As we will see, viewing the firm’s capitalization in this way yields important insights
NPV net present value into the firm’s capital structure as well as the conflicts of interests that arise between
equity investors and debt investors.
Before we can discuss the corporate applications of options, we first need to
understand what options are and what factors affect their value. In this chapter, we
provide an overview of the basic types of financial options, introduce important termi-
nology, and describe the payoffs to various option-based strategies. We next discuss
the factors that affect option prices. Finally, we model the equity and debt of the firm
as options to gain insight into the conflicts of interest between equity and debt holders,
as well as the pricing of risky debt.
756
20.1â•‡ Option Basics 757
20.1 Option Basics

A financial option contract gives its owner the right (but not the obligation) to purchase
or sell an asset at a fixed price at some future date. Two distinct kinds of option contracts
exist: call options and put options. A call option gives the owner the right to buy the asset;
a put option gives the owner the right to sell the asset. Because an option is a contract
between two parties, for every owner of a financial option, there is also an option writer,
the person who takes the other side of the contract.
The most commonly encountered option contracts are options on shares of stock. A
stock option gives the holder the option to buy or sell a share of stock on or before a given
date for a given price. For example, a call option on 3M Corporation stock might give the
holder the right to purchase a share of 3M for $75 per share at any time up to, for example,
January 18, 2019. Similarly, a put option on 3M stock might give the holder the right to
sell a share of 3M stock for $50 per share at any time up to, say, January 19, 2018.
Understanding Option Contracts

Practitioners use specific words to describe the details of option contracts. When a holder
of an option enforces the agreement and buys or sells a share of stock at the agreed-upon
price, he is exercising the option. The price at which the holder buys or sells the share of
stock when the option is exercised is called the strike price or exercise price.
There are two kinds of options. American options, the most common kind, allow
their holders to exercise the option on any date up to and including a final date called the
expiration date. European options allow their holders to exercise the option only on the
expiration date—holders cannot exercise before the expiration date. The names American
and European have nothing to do with the location where the options are traded: Both
types are traded worldwide.
An option contract is a contract between two parties. The option buyer, also called the
option holder, holds the right to exercise the option and has a long position in the contract.
The option seller, also called the option writer, sells (or writes) the option and has a short
position in the contract. Because the long side has the option to exercise, the short side
has an obligation to fulfill the contract. For example, suppose you own a call option on
Hewlett-Packard stock with an exercise price of $10. Hewlett-Packard stock is currently
trading for $25, so you decide to exercise the option. The person holding the short position
in the contract is obligated to sell you a share of Hewlett-Packard stock for $10. Your gain,
the $15 difference between the price you pay for the share of stock and the price at which
you can sell the share in the market, is the short position’s loss.
Investors exercise options only when they stand to gain something. Consequently,
whenever an option is exercised, the person holding the short position funds the gain.
That is, the obligation will be costly. Why, then, do people write options? The answer is
that when you sell an option you get paid for it—options always have positive prices. The
market price of the option is also called the option premium. This upfront payment com-
pensates the seller for the risk of loss in the event that the option holder chooses to exercise
the option.
Interpreting Stock Option Quotations

Stock options are traded on organized exchanges. The oldest and largest is the Chicago
Board Options Exchange (CBOE). By convention, all traded options expire on the
Â�Saturday following the third Friday of the month.
758 Chapter 20â•‡ Financial Options
Table 20.1 Option Quotes for Amazon.com Stock
AMZN 77.03 +1.40

Jul 08 2009 @ 15:26 ET Bid 77.02 Ask 77.03 Size 1 x 3 Vol 6548487
Last Open Last Open
Calls Net Bid Ask Vol Puts Net Bid Ask Vol
Sale Int Sale Int
09 Jul 70.00 (ZQN GN-E) 7.65 1.60 7.20 7.30 221 2637 09 Jul 70.00 (ZQN SN-E) 0.36 –0.18 0.36 0.38 684 11031
09 Jul 75.00 (ZQN GO-E) 3.35 0.86 3.20 3.30 943 6883 09 Jul 75.00 (ZQN SO-E) 1.30 –0.66 1.38 1.40 2394 15545
09 Jul 80.00 (QZN GP-E) 0.94 0.24 0.93 0.96 2456 9877 09 Jul 80.00 (QZN SP-E) 4.15 –1.05 4.00 4.10 700 10718
09 Jul 85.00 (QZN GQ-E) 0.22 0.07 0.19 0.21 497 26679 09 Jul 85.00 (QZN SQ-E) 8.25 –1.25 8.25 8.35 112 7215
09 Aug 70.00 (ZQN HN-E) 9.75 1.04 9.60 9.70 51 326 09 Aug 70.00 (ZQN TN-E) 2.77 –0.39 2.75 2.79 225 1979
09 Aug 75.00 (ZQN HO-E) 6.50 0.70 6.40 6.50 65 1108 09 Aug 75.00 (ZQN TO-E) 4.60 –0.55 4.55 4.60 2322 6832
09 Aug 80.00 (QZN HP-E) 4.00 0.50 3.90 4.00 172 2462 09 Aug 80.00 (QZN TP-E) 6.95 –0.95 7.05 7.15 145 2335
09 Aug 85.00 (QZN HQ-E) 2.15 0.15 2.22 2.26 833 5399 09 Aug 85.00 (QZN TQ-E) 10.15 –1.00 10.30 10.40 43 4599
Source: Chicago Board Options Exchange at www.cboe.com
TableÂ€20.1 shows near-term options on Amazon taken from the CBOE Web site (www
.cboe.com) on July 8, 2009. Call options are listed on the left and put options on the right.
Each line corresponds to a particular option. The first two digits in the option name refer
to the year of expiration. The option name also includes the month of expiration, the strike
or exercise price, and the ticker symbol of the individual option (in parentheses). Looking
at TableÂ€20.1, the first line of the left column is a call option with an exercise price of $70
that expires on the Saturday following the third Friday of July 2009 ( July 18). The Â�columns
to the right of the name display market data for the option. The first of these columns
shows the last sale price, followed by the net change from the previous day’s last reported
sales price, the current bid and ask prices, and the daily volume.1 The final column is the
open interest, the total number of outstanding contracts of that option.
Above the table, we find information about the stock itself. In this case, Amazon’s stock last
traded at a price of $77.03 per share. We also see the current bid and ask prices for the stock,
the size trade (in hundreds of shares) available at these prices, as well as the volume of trade.
When the exercise price of an option is equal to the current price of the stock, the
option is said to be at-the-money. Notice that, especially for the near-term options, much
of the trading occurs in options that are closest to being at-the-money—that is, calls and
puts with exercise prices of either $75 or $80. Note how the July 80 calls have high volume.
They last traded for $0.94, midway between the current bid price ($0.93) and the ask price
($0.96), which indicates that the trade likely occurred recently. If it were not recent, the
last sale price might be far from the current bid and ask.
Stock option contracts are always written on 100 shares of stock. If, for instance, you
decided to purchase one July 75 call contract, you would be purchasing an option to buy
100 shares at $75 per share. Option prices are quoted on a per-share basis, so the ask price
of $3.30 implies that you would pay 100 * 3.30 = $330 for the contract. Similarly, if you
decide to buy a July 70 put contract, you would pay 100 * 0.38 = $38 for the option to
sell 100 shares of Amazon stock for $70 per share.
1
If no trade has occurred that day, the last sale price is from the previous day, and “pc” appears in the net
change column.
20.1â•‡ Option Basics 759
Note from TableÂ€20.1 that for each expiration date, call options with lower strike prices
have higher market prices—the right to buy the stock at a lower price is more valuable
than the right to buy it for a higher price. Conversely, because the put option gives the
holder the right to sell the stock at the strike price, for the same expiration date, puts with
higher strikes are more valuable. On the other hand, holding fixed the strike price, both
calls and puts are more expensive for a longer time to expiration. Because these options are
American-style options that can be exercised at any time, having the right to buy or sell for
a longer period is more valuable.
If the payoff from exercising an option immediately is positive, the option is said to be
in-the-money. Call options with strike prices below the current stock price are in-the-
money, as are put options with strike prices above the current stock price. Conversely, if the
payoff from exercising the option immediately is negative, the option is out-of-the-money.
Call options with strike prices above the current stock price are out-of-the-money, as are
put options with strike prices below the current stock price. Of course, a holder would not
exercise an out-of-the-money option. Options where the strike price and the stock price are
very far apart are referred to as deep in-the-money or deep out-of-the-money.
Example 20.1 Purchasing Options
Problem
It is the afternoon of July 8, 2009, and you have decided to purchase 10 August call contracts on
Amazon stock with an exercise price of $80. Because you are buying, you must pay the ask price.
How much money will this purchase cost you? Is this option in-the-money or out-of-the-money?
Solution
From TableÂ€20.1, the ask price of this option is $4.00. You are purchasing 10 contracts and each
contract is on 100 shares, so the transaction will cost 4.00 * 10 * 100 = $4,000 (ignoring any
brokerage fees). Because this is a call option and the exercise price is above the current stock price
($77.03), the option is currently out-of-the-money.
Options on Other Financial Securities

Although the most commonly traded options are written on stocks, options on other finan-
cial assets do exist. Perhaps the most well-known are options on stock indexes such as the
S&P 100 index, the S&P 500 index, the Dow Jones Industrial index, and the NYSE index.
These options have become very popular because they allow investors to protect the value
of their investments from adverse market changes. As we will see shortly, a stock index put
option can be used to offset the losses on an investor’s portfolio in a market downturn.
Using an option to reduce risk in this way is called hedging. Options also allow investors
to speculate, or place a bet on the direction in which they believe the market is likely to
move. Purchasing a call, for example, allows investors to bet on a market rise with a much
smaller investment than investing in the market index itself.
Options are also traded on Treasury securities. These options allow investors to bet on
or hedge interest rate risk. Similarly, options on currencies and commodities allow inves-
tors to hedge or speculate on risks in these markets.
Concept Check 1. What is the difference between an American option and a European option?
2. Does the holder of an option have to exercise it?
3. Why does an investor who writes (shorts) an option have an obligation?
20.2 Option Payoffs at Expiration

From the Law of One Price, the value of any security is determined by the future cash
flows an investor receives from owning it. Therefore, before we can assess what an option is
worth, we must determine an option’s payoff at the time of expiration.
Long Position in an Option Contract

Assume you own an option with a strike price of $20. If, on the expiration date, the stock
price is greater than the strike price, say $30, you can make money by exercising the call
(by paying $20, the strike price, for the stock) and immediately selling the stock in the
open market for $30. The $10 difference is what the option is worth. Consequently, when
the stock price on the expiration date exceeds the strike price, the value of the call is the
difference between the stock price and the strike price. When the stock price is less than
the strike price at expiration, the holder will not exercise the call, so the option is worth
nothing. We plot these payoffs in FigureÂ€20.1.2
Thus, if S is the stock price at expiration, K is the exercise price, and C is the value of the
call option, the value of the call at expiration is
Call Value at Expiration
C = max(S - K, 0) (20.1)
Figure 20.1
40
Payoff of a Call Option
with a Strike Price of
$20 at Expiration 30
If the stock price is greater

Payoff ($)
than the strike price ($20),

the call will 20
be exercised, and the
holder’s payoff is the dif-
ference between the stock 10
Strike Price
price and the strike price. If
the stock price is less than
the strike price, the call will 0
not be exercised,
Â� and so has 0 10 20 30 40 50 60
no value. Stock Price ($)
2
Payoff diagrams like the ones in this chapter seem to have been introduced by Louis Bachelier in 1900 in
his book, Theorie de la Speculation (Villars, 1900). Reprinted in English in P. Cootner (ed.), The Random
Character of Stock Market Prices (M.I.T. Press, 1964).
20.2â•‡ Option Payoffs at Expiration 761
where max is the maximum of the two quantities in the parentheses. The call’s value is the
maximum of the difference between the stock price and the strike price, S - K, and zero.
The holder of a put option will exercise the option if the stock price S is below the strike
price K. Because the holder receives K when the stock is worth S, the holder’s gain is equal
to K - S. Thus, the value of a put at expiration is
Put Price at Expiration
P = max(K - S, 0) (20.2)
Example 20.2 Payoff of a Put Option at Maturity
Problem
You own a put option on Oracle Corporation stock with an exercise price of $20 that expires
today. Plot the value of this option as a function of the stock price.
Solution
Let S be the stock price and P be the value of the put option. The value of the option is
P = max(20 - S, 0)
Plotting this function gives
20
15
Payoff ($)
10
Strike Price
5
0
0 10 20 30 40
Stock Price ($)
Short Position in an Option Contract

An investor holding a short position in an option has an obligation: This investor takes the
opposite side of the contract to the investor who is long. Thus, the short position’s cash
flows are the negative of the long position’s cash flows. Because an investor who is long
an option can only receive money at expiration—that is, the investor will not exercise an
option that is out-of-the-money—a short investor can only pay money.
To demonstrate, assume you have a short position in a call option with an exercise price
of $20. If the stock price is greater than the strike price of a call—for example, $25—the
holder will exercise the option. You then have the obligation to sell the stock for the strike
price of $20. Because you must purchase the stock at the market price of $25, you lose
theÂ€difference between the two prices, or $5. However, if the stock price is less than the
strike price at the expiration date, the holder will not exercise the option, so in this case you
lose nothing; you have no obligation. We plot these payoffs in FigureÂ€20.2.
Figure 20.2â•‡
Stock Price ($)
0 10 20 30 40 50 60
Short Position in a Call 0
Option at Expiration
If the stock price is greater Strike Price
than the strike price, the 10
call will be exercised, so a
person on the short side of
Payoff ($)
a call will lose the difference 20
between the stock price and
the strike price. If the stock
price is less than the strike
30
price, the call will not be
exercised, and the seller will
have no obligation.
40
Example 20.3 Payoff of a Short Position in a Put Option
Problem
You are short in a put option on Oracle Corporation stock with an exercise price of $20 that
expires today. What is your payoff at expiration as a function of the stock price?
Solution
If S is the stock price, your cash flows will be
- max(20 - S, 0)
If the current stock price is $30, then the put will not be exercised and you will owe nothing.
If the current stock price is $15, the put will be exercised and you will lose $5. The figure plots
your cash flows:
Stock Price ($)

10 20 30 40
00
5
Strike Price
Payoff ($)
10
15
20
Notice that because the stock price cannot fall below zero, the downside for a short posi-
tion in a put option is limited to the strike price of the option, as in Example 20.3. A short
position in a call, however, has no limit on the downside (see FigureÂ€20.2).
Figure 20.3â•‡
25
09 Aug 70 Call
Profit from Holding a Call 20
09 Aug 75 Call
Profit on Expiration Date ($)

Option to Expiration
The curves show the profit 15 09 Aug 80 Call
per share from purchasing 09 Aug 85 Call
10
the August call options in
Table 20.1 on July 8, 2009,
5
financing this purchase by
borrowing at 3%, and 55 60 65 70 75 80 85 90 95 100
0
holding the position until
the expiration date. –5
–10
–15 Stock Price ($)
Profits for Holding an Option to Expiration

Although payouts on a long position in an option contract are never negative, the profit
from purchasing an option and holding it to expiration could well be negative because the
payout at expiration might be less than the initial cost of the option.
To see how this works, let’s consider the potential profits from purchasing the 09 August
80 call option on Amazon stock quoted in TableÂ€20.1. The option costs $4.00 and expires
in 45 days. Assume you choose to finance the purchase by borrowing $4.00 at an interest
rate of 3% per year. If the stock price at expiration is S, then the profit is the call payoff
minus the amount owed on the loan: max(S - 80, 0) - 4.00 * 1.0345/365, shown as the red
curve in FigureÂ€20.3. Once the cost of the position is taken into account, you make a posi-
tive profit only if the stock price exceeds $84.01. As we can see from TableÂ€20.1, the further
in-the-money the option is, the higher its initial price and so the larger your potential loss.
An out-of-the-money option has a smaller initial cost and hence a smaller potential loss,
but the probability of a gain is also smaller because the point where profits become positive
is higher.
Because a short position in an option is the other side of a long position, the profits
from a short position in an option are just the negative of the profits of a long position. For
example, a short position in an out-of-the-money call like the 09 August 85 Amazon call in
FigureÂ€20.3 produces a small positive profit if Amazon’s stock is below $87.23, but leads to
losses if the stock price is above $87.23.
Example 20.4 Profit on Holding a Position in a Put Option until Expiration
Problem
Assume you decided to purchase each of the August put options quoted in TableÂ€20.1 on July 8,
2009, and you financed each position by shorting a two-month bond with a yield of 3%. Plot
the profit of each position as a function of the stock price on expiration.
Solution
Suppose S is the stock price on expiration, K is the strike price, and P is the price of each put
option on July 8. Then your cash flows on the expiration date will be
max(K - S, 0) - P * 1.03 45/365
The plot is shown below. Note the same trade-off between the maximum loss and the Â�potential
for profit as for the call options.
25
20 09 Aug 85 Put
09 Aug 80 Put
Profit on Expiration Date ($)
15
09 Aug 75 Put
10 09 Aug 70 Put
5
55 60 65 70 75 80 85 90 95 100
0
–5
–10
–15 Stock Price ($)
Returns for Holding an Option to Expiration

We can also compare options based on their potential returns. FigureÂ€ 20.4 shows the
return from purchasing one of the August 2009 options in TableÂ€20.1 on July 8, 2009, and
holding it until the expiration date. Let’s begin by focusing on call options, shown in panel
(a). In all cases, the maximum loss is 100%—the option may expire worthless. Notice how
the curves change as a function of the strike price—the distribution of returns for out-of-
the-money call options are more extreme than those for in-the-money calls. That is, an
out-of-the-money call option is more likely to have a - 100% return, but if the stock goes
up sufficiently it will also have a much higher return than an in-the-money call option.
Similarly, all call options have more extreme returns than the stock itself (given Amazon’s
initial price of $77.03, the range of stock prices shown in the plot represents returns
ofÂ€{ 30%). As a consequence, the risk of a call option is amplified relative to the risk of the
stock, and the amplification is greater for deeper out-of-the-money calls. Thus, if a stock
had a positive beta, call options written on the stock will have even higher betas and
expected returns than the stock itself.3
Now consider the returns for put options. Look carefully at panel (b) in FigureÂ€20.4. The
put position has a higher return with low stock prices; that is, if the stock has a positive beta,
the put has a negative beta. Hence, put options on positive beta stocks have lower expected
returns than the underlying stock. The deeper out-of-the-money the put option is, the more
negative its beta, and the lower its expected return. As a result, put options are generally not
held as an investment, but rather as insurance to hedge other risk in a portfolio.
3
In ChapterÂ€21, we explain how to calculate the expected return and risk of an option. In doing so, we will
derive these relations rigorously.
Figure 20.4â•‡ Option Returns from Purchasing an Option and Holding It to Expiration
600% 500%
09 Aug 70 Put
09 Aug 85 Call
500% 400%
09 Aug 75 Put
400% 09 Aug 80 Call 300%
Return (%)
Return (%)
300% 09 Aug 80 Put
09 Aug 75 Call
200%
200% 09 Aug 85 Put
09 Aug 70 Call
100%
100%
0% 0%
55 60 65 70 75 80 85 90 95 100 55 60 65 70 75 80 85 90 95 100
100% 100%
Stock Price ($) Stock Price ($)

(a) (b)
(a) The return on the expiration date from purchasing one of the August call options in Table 20.1 on July 8, 2009, and
holding the position until the expiration date; (b) the same return for the August put options in the table.
Combinations of Options
Sometimes investors combine option positions by holding a portfolio of options. In this
section, we describe the most common combinations.
Straddle.â•‡ What would happen at expiration if you were long both a put option and a call
option with the same strike price? FigureÂ€20.5 shows the payout on the expiration date of
both options.
Figure 20.5â•‡
K Payoff
Payoff and Profit from
a Straddle Profit
Put Call
A combination of a long position
in a put and a call with the same
strike price and expiration date
provides a positive payoff (solid $
line) so long as the stock price
does not equal the strike price.
After deducting the cost of the
options, the profit is negative for Strike Price
stock prices close to the strike
price and positive elsewhere
(dashed line). 0
K
Stock Price ($)

By combining a call option (blue line) with a put option (red line), you will receive
cash so long as the options do not expire at-the-money. The farther away from the money
the options are, the more money you will make (solid line). However, to construct the
combination requires purchasing both options, so the profits after deducting this cost are
negative for stock prices close to the strike price and positive elsewhere (dashed line). This
combination of options is known as a straddle. This strategy is sometimes used by inves-
tors who expect the stock to be very volatile and move up or down a large amount, but
who do not necessarily have a view on which direction the stock will move. Conversely,
investors who expect the stock to end up near the strike price may choose to sell a straddle.
Example 20.5 Strangle
Problem
You are long both a call option and a put option on Hewlett-Packard stock with the same expira-
tion date. The exercise price of the call option is $40; the exercise price of the put option is $30.
Plot the payoff of the combination at expiration.
Solution
The red line represents the put’s payouts and the blue line represents the call’s payouts. In this
case, you do not receive money if the stock price is between the two strike prices. This option
combination is known as a strangle.
40
30
Call
Payoff ($)
20 Put
10
0
0 20 40 60 80
Stock Price ($)
Butterfly Spread.â•‡ The combination of options in FigureÂ€ 20.5 makes money when the
stock and strike prices are far apart. It is also possible to construct a combination of options
with the opposite exposure: one that pays off when the stock price is close to the strike price.
Suppose you are long two call options with the same expiration date on Intel stock:
one with an exercise price of $20 and the other with an exercise price of $40. In addition,
suppose you are short two call options on Intel stock, both with an exercise price of $30.
FigureÂ€20.6 plots the value of this combination at expiration.
The yellow line in FigureÂ€20.6 represents the payoff at expiration from the long position
in the $20 call. The red line represents the payoff from the long position in the $40 call.
The blue line represents the payoff from the short position in the two $30 calls. The black
line shows the payoff of the entire combination. For stock prices less than $20, all options
are out-of-the-money, so the payoff is zero. For stock prices greater than $40, the losses
from the short position in the $30 calls exactly offset the gain from $20 and $40 options,
Figure 20.6â•‡
30
Butterfly Spread 25
The yellow line represents
20 20 Call
the payoff from a long
position in a $20 call. The 15
red line represents the
10
payoff from a long position
40 Call
in a $40 call. The blue 5
Payoff ($)
line represents the payoff
0
from a short position in
15 20 25 30 35 40 45
two $30 calls. The black 5
line shows the payoff of
the entire combination, 10
called a butterfly spread, at 15
expiration. 2 30 Call
20
25
30
Stock Price ($)
and the value of the entire portfolio of options is zero.4 Between $20 and $40, however, the
payoff is positive. It reaches a maximum at $30. Practitioners call this combination of
options a butterfly spread.
Because the payoff of the butterfly spread is positive, it must have a positive initial cost.
(Otherwise, it would be an arbitrage opportunity.) Therefore, the cost of the $20 and $40
call options must exceed the proceeds from selling two $30 call options.
Portfolio Insurance.â•‡ Let’s see how we can use combinations of options to insure a stock
against a loss. Assume you currently own Amazon stock and you would like to insure the
stock against the possibility of a price decline. To do so, you could simply sell the stock,
but you would also give up the possibility of making money if the stock price increases.
How can you insure against a loss without relinquishing the upside? You can purchase a
put option, sometimes known as a protective put.
For example, suppose you want to insure against the possibility that the price of Ama-
zon stock will drop below $45. You decide to purchase an August 45 European put option.
If Amazon stock is above $45 in August, you keep the stock, but if it is below $45 you
exercise your put and sell it for $45. Thus, you get the upside, but are insured against a
drop in the price of Amazon’s stock. The orange line in FigureÂ€20.7 (a) shows the value of
the combined position on the expiration date of the option.
You can use the same strategy to insure against a loss on an entire portfolio of stocks by using
put options on the portfolio of stocks as a whole rather than just a single stock. Consequently,
holding stocks and put options in this combination is known as portfolio insurance.
Purchasing a put option is not the only way to buy portfolio insurance. You can achieve
exactly the same effect by purchasing a bond and a call option. Let’s return to the insurance
we purchased on Amazon stock. Amazon stock does not pay dividends, so there are no cash
4
To see this, note that (S - 20) + (S - 40) - 2(S - 30) = 0.
Figure 20.7â•‡ Portfolio Insurance
75 75
Riskless Bond Call
60 60
Stock Put
Payoff ($)
Payoff ($)
45 45
Riskless Bond
30 30
15 Stock 15
0 0
0 15 30 45 60 75 0 15 30 45 60 75
Stock Price ($) Stock Price ($)
(a) (b)
The plots show two different ways to insure against the possibility of the price of Amazon stock falling below $45. The
orange line in (a) indicates the value on the expiration date of a position that is long one share of Amazon
Â� stock and one
European put option with a strike of $45 (the blue dashed line is the payoff of the stock itself). The orange line in (b) shows
the value on the expiration date of a position that is long a zero-coupon risk-free bond with a face value of $45 and
a European call option on Amazon with a strike price of $45 (the green dashed line is the bond payoff).
flows before the expiration of the option. Thus, instead of holding a share of Amazon stock
and a put, you could get the same payoff by purchasing a risk-free zero-coupon bond with
a face value of $45 and a European call option with a strike price of $45. In this case, if
Amazon is below $45, you receive the payoff from the bond. If Amazon is above $45, you
can exercise the call and use the payoff from the bond to buy the stock for the strike price
of $45. The orange line in FigureÂ€20.7(b) shows the value of the combined position on the
expiration date of the option; it achieves exactly the same payoffs as owning the stock itself
along with a put option.
Concept Check 1. What is a straddle?

2. Explain how you can use put options to create portfolio insurance. How can you create portfolio
insurance using call options?
20.3 Put-Call Parity

Consider the two different ways to construct portfolio insurance illustrated in FigureÂ€20.7:
(1) purchase the stock and a put or (2) purchase a bond and a call. Because both positions
provide exactly the same payoff, the Law of One Price requires that they must have the
same price.
Let’s write this concept more formally. Let K be the strike price of the option (the price
we want to ensure that the stock will not drop below), C be the call price, P be the put
price, and S be the stock price. Then, if both positions have the same price,
S + P = PV(K ) + C
20.3â•‡ Put-Call Parity 769
The left side of this equation is the cost of buying the stock and a put (with a strike price
of K ); the right side is the cost of buying a zero-coupon bond with face value K and a call
option (with a strike price of K ). Recall that the price of a zero-coupon bond is just the
present value of its face value, which we have denoted by PV(K ). Rearranging terms gives
an expression for the price of a European call option for a non-dividend-paying stock:
C = P + S - PV(K ) (20.3)
This relationship between the value of the stock, the bond, and call and put options is
known as put-call parity. It says that the price of a European call equals the price of the
stock plus an otherwise identical put minus the price of a bond that matures on the exercise
date of the option. In other words, you can think of a call as a combination of a levered posi-
tion in the stock, S - PV(K ), plus insurance against a drop in the stock price, the put P.
Example 20.6 Using Put-Call Parity
Problem
You are an options dealer who deals in non-publicly traded options. One of your clients wants to
purchase a one-year European call option on HAL Computer Systems stock with a strike price
of $20. Another dealer is willing to write a one-year European put option on HAL stock with
a strike price of $20, and sell you the put option for a price of $3.50 per share. If HAL pays no
dividends and is currently trading for $18 per share, and if the risk-free interest rate is 6%, what
is the lowest price you can charge for the option and guarantee yourself a profit?
Solution
Using put-call parity, we can replicate the payoff of the one-year call option with a strike price of
$20 by holding the following portfolio: Buy the one-year put option with a strike price of $20
from the dealer, buy the stock, and sell a one-year risk-free zero-coupon bond with a face value
of $20. With this combination, we have the following final payoff depending on the final price
of HAL stock in one year, S1:
Final HAL Stock Price
S1 * $20 S1 + $20
Buy Put Option 20 - S1 0
Buy Stock S1 S1
Sell Bond - 20 - 20
Portfolio 0 S1 - 20
Sell Call Option 0 - (S1 - 20)
Total Payoff 0 0
Note that the final payoff of the portfolio of the three securities matches the payoff of a call
option. Therefore, we can sell the call option to our client and have future payoff of zero no mat-
ter what happens. Doing so is worthwhile as long as we can sell the call option for more than the
cost of the portfolio, which is
P + S - PV(K ) = $3.50 + $18 - $20/1.06 = $2.632
What happens if the stock pays a dividend? In that case, the two different ways to
construct portfolio insurance do not have the same payout because the stock will pay a
dividend while the zero-coupon bond will not. Thus, the two strategies will cost the same
M20_BERK0160_04_GE_C20.indd 769 8/20/16 11:52 AM

to implement only if we add the present value of future dividends to the combination of
the bond and the call:
S + P = PV(K ) + PV(Div) + C
The left side of this equation is the value of the stock and a put; the right side is the value
of a zero-coupon bond, a call option, and the future dividends paid by the stock during
the life of the options, denoted by Div. Rearranging terms gives the general put-call parity
formula:
Put-Call Parity
C = P + S - PV(Div) - PV(K ) (20.4)
In this case, the call is equivalent to having a levered position in the stock without divi-
dends plus insurance against a fall in the stock price.
Example 20.7 Using Options to Value Near-Term Dividends
Problem
It is February 2016 and you have been asked, in your position as a financial analyst, to compare
the expected dividends of several popular stock indices over the next several years. Checking
the markets, you find the following closing prices for each index, as well as for options expiring
December 2018.
Feb 2016 Dec 2018 Index Options

Index Index Value Strike Price Call Price Put Price
DJIA 164.85 160 19.78 22.73
S&P 500 1929.80 1900 243.25 278.00
Nasdaq 100 4200.66 4200 636.35 666.85
Russell 2000 1022.08 1000 150.10 166.80
If the current risk-free interest rate is 0.90% for a December 2018 maturity, estimate the relative
contribution of the near-term dividends to the value of each index.
Solution
Rearranging the Put-Call Parity relation gives:
PV (Div) = P - C + S - PV (K )
Applying this to the DJIA, we find that the expected present value of its dividends over the next
34 months is
160
PV (Div) = 22.73 - 19.78 + 164.85 - = 11.81
1.00934/12
Therefore, expected dividends through December 2018 represent 11.81/164.85 = 7.2% of the
current value of DJIA index. Doing a similar calculation for the other indices, we find that near-
term dividends account for 5.8% of the value of the S&P 500, 3.2% of the NASDAQ 100, and
6.2% of the Russell 2000.
Concept Check 1. Explain put-call parity.

2. If a put option trades at a higher price from the value indicated by the put-call parity equation,
what action should you take?
M20_BERK0160_04_GE_C20.indd 770 8/20/16 11:52 AM

20.4â•‡ Factors Affecting Option Prices 771
20.4 Factors Affecting Option Prices

Put-call parity gives the price of a European call option in terms of the price of a European
put, the underlying stock, and a zero-coupon bond. Therefore, to compute the price of a
call using put-call parity, you have to know the price of the put. In ChapterÂ€21, we explain
how to calculate the price of a call without knowing the price of the put. Before we get
there, let’s first investigate the factors that affect option prices.
Strike Price and Stock Price

As we noted earlier for the Amazon option quotes in TableÂ€20.1, the value of an other-
wise identical call option is higher if the strike price the holder must pay to buy the stock
is lower. Because a put is the right to sell the stock, puts with a lower strike price are less
valuable.
For a given strike price, the value of a call option is higher if the current price of the stock
is higher, as there is a greater likelihood the option will end up in-the-money. Conversely,
put options increase in value as the stock price falls.
Arbitrage Bounds on Option Prices

We have already seen that an option’s price cannot be negative. Furthermore, because
an American option carries all the same rights and privileges as an otherwise equivalent
European option, it cannot be worth less than a European option. If it were, you could
make arbitrage profits by selling a European call and using part of the proceeds to buy an
otherwise equivalent American call option. Thus, an American option cannot be worth less
than its European counterpart.
The maximum payoff for a put option occurs if the stock becomes worthless (if, say,
the company files for bankruptcy). In that case, the put’s payoff is equal to the strike price.
Because this payoff is the highest possible, a put option cannot be worth more than its strike
price.
For a call option, the lower the strike price, the more valuable the call option. If the call
option had a strike price of zero, the holder would always exercise the option and receive
the stock at no cost. This observation gives us an upper bound on the call price: A call
option cannot be worth more than the stock itself.
The intrinsic value of an option is the value it would have if it expired immediately.
Therefore, the intrinsic value is the amount by which the option is currently in-the-money,
or zero if the option is out-of-the-money. If an American option is worth less than its
intrinsic value, you could make arbitrage profits by purchasing the option and immediately
exercising it. Thus, an American option cannot be worth less than its intrinsic value.
The time value of an option is the difference between the current option price and its
intrinsic value. Because an American option cannot be worth less than its intrinsic value, it
cannot have a negative time value.
Option Prices and the Exercise Date

For American options, the longer the time to the exercise date, the more valuable the
option. To see why, let’s consider two options: an option with one year until the exercise
date and an option with six months until the exercise date. The holder of the one-year
option can turn her option into a six-month option by simply exercising it early. That is,
the one-year option has all the same rights and privileges as the six-month option, so by the
Law of One Price, it cannot be worth less than the six-month option: An American option
with a later exercise date cannot be worth less than an otherwise identical American option with
an earlier exercise date. Usually the right to delay exercising the option is worth something,
so the option with the later exercise date will be more valuable.
What about European options? The same argument will not work for European
options, because a one-year European option cannot be exercised early at six months. As
a consequence, a European option with a later exercise date may potentially trade for less
than an otherwise identical option with an earlier exercise date. For example, think about
a European call on a stock that pays a liquidating dividend in eight months (a liquidating
dividend is paid when a corporation chooses to go out of business, sells off all of its assets,
and pays out the proceeds as a dividend). A one-year European call option on this stock
would be worthless, but a six-month call would be worth something.
Option Prices and Volatility

An important criterion that determines the price of an option is the volatility of the under-
lying stock. Consider the following simple example.
Example 20.8 Option Value and Volatility
Problem
Two European call options with a strike price of $50 are written on two different stocks. Suppose
that tomorrow, the low-volatility stock will have a price of $50 for certain. The high-volatility
stock will be worth either $60 or $40, with each price having equal probability. If the exercise
date of both options is tomorrow, which option will be worth more today?
Solution
The expected value of both stocks tomorrow is $50—the low-volatility stock will be worth this
amount for sure, and the high-volatility stock has an expected value of 12 ($40) + 12 ($60) = $50.
However, the options have very different values. The option on the low-volatility stock is worth
nothing because there is no chance it will expire in-the-money (the low-volatility stock will be
worth $50 and the strike price is $50). The option on the high-volatility stock is worth a posi-
tive amount because there is a 50% chance that it will be worth $60 - $50 = $10, and a 50%
chance that it will be worthless. The value today of a 50% chance of a positive payoff (with no
chance of a loss) is positive.
Example 20.8 illustrates an important principle: The value of an option generally increases
with the volatility of the stock. The intuition for this result is that an increase in volatility
increases the likelihood of very high and very low returns for the stock. The holder of a call
option benefits from a higher payoff when the stock goes up and the option is in-the-
money, but earns the same (zero) payoff no matter how far the stock drops once the option
is out-of-the-money. Because of this asymmetry of the option’s payoff, an option holder
gains from an increase in volatility.5
Recall that adding a put option to a portfolio is akin to buying insurance against a
decline in value. Insurance is more valuable when there is higher volatility—hence put
options on more volatile stocks are also worth more.
5
This relation between the stock’s volatility and the value of an option holds for realistic distributions of
stock prices assumed by practitioners (described in detail in ChapterÂ€21), in which an increase in volatility
implies a more “spread out” distribution for the entire range of future stock prices. That said, it need not
hold, for example, if the volatility of the stock increases in some ranges but falls in others.
20.5â•‡ Exercising Options Early 773
Concept Check 1. What is the intrinsic value of an option?

2. Can a European option with a later exercise date be worth less than an identical European option
with an earlier exercise date?
3. How does the volatility of a stock affect the value of puts and calls written on the stock?
20.5 Exercising Options Early

One might guess that the ability to exercise the American option early would make an
American option more valuable than an equivalent European option. Surprisingly, this is
not always the case—sometimes, they have equal value. Let’s see why.
Non-Dividend-Paying Stocks
Let’s consider first options on a stock that will not pay any dividends prior to the expira-
tion date of the options. In that case, the put-call parity formula for the value of the call
option is (see Eq. 20.3):
C = P + S - PV(K )
We can write the price of the zero-coupon bond as PV(K ) = K - dis(K ), where dis(K )
is the amount of the discount from face value to account for interest. Substituting this
expression into put-call parity gives
C=S-K + dis(K ) + P (20.5)

¸˚˚˚˝˚˚˚˛ ¸˚˚˚˝˚˚˚˛
Intrinsic value Time value
In this case, both terms that make up the time value of the call option are positive
before the expiration date: As long as interest rates remain positive, the discount on a zero-
coupon bond before the maturity date is positive, and the put price is also positive, so a
European call always has a positive time value. Because an American option is worth at
least as much as a European option, it must also have a positive time value before
Â�expiration. Hence, the price of any call option on a non-dividend-paying stock always exceeds
its intrinsic value.6
This result implies that it is never optimal to exercise a call option on a non-dividend-
paying stock early—you are always better off just selling the option. It is straightforward to
see why. When you exercise an option, you get its intrinsic value. But as we have just seen,
the price of a call option on a non-dividend-paying stock always exceeds its intrinsic value.
Thus, if you want to liquidate your position in a call on a non-dividend-paying stock, you
will get a higher price if you sell it rather than exercise it. Because it is never optimal to
exercise an American call on a non-dividend-paying stock early, the right to exercise the call
early is worthless. For this reason, an American call on a non-dividend-paying stock has the
same price as its European counterpart.
To understand the economics underlying this result, note that there are two benefits to
delaying the exercise of a call option. First, the holder delays paying the strike price, and
second, by retaining the right not to exercise, the holder’s downside is limited. (These ben-
efits are represented by the discount and put values in Eq. 20.5.)
6
This conclusion would not hold if the interest rate faced by traders is negative; in that case the results for
calls and puts in this section would be reversed.
What about an American put option on a non-dividend-paying stock? Does it ever

make sense to exercise it early? The answer is yes, under certain circumstances. To see why,
note that we can rearrange the put-call parity relationship as expressed in Eq. 20.5 to get
the price of a European put option:
P=K-S + C - dis(K ) (20.6)

¸˚˚˚˝˚˚˚˛ ¸˚˚˚˝˚˚˚˛
In this case, the time value of the option includes a negative term, the discount on a bond
with face value K; this term represents the opportunity cost of waiting to receive the strike
price K. When the strike price is high and the put option is sufficiently deep in-the-money,
this discount will be large relative to the value of the call, and the time value of a European put
option will be negative. In that case, the European put will sell for less than its intrinsic value.
However, its American counterpart cannot sell for less than its intrinsic value (because other-
wise arbitrage profits would be possible by immediately exercising it), which implies that the
American option can be worth more than an otherwise identical European option. Because the
only difference between the two options is the right to exercise the option early, this right must
be valuable—there must be states in which it is optimal to exercise the American put early.
Let’s examine an extreme case to illustrate when it is optimal to exercise an American
put early: Suppose the firm goes bankrupt and the stock is worth nothing. In such a case,
the value of the put equals its upper bound—the strike price—so its price cannot go any
higher. Thus, no future appreciation is possible. However, if you exercise the put early,
you can get the strike price today and earn interest on the proceeds in the interim. Hence
it makes sense to exercise this option early. Although this example is extreme, it illustrates
that it can be optimal to exercise deep in-the-money put options early.
Example 20.9 Early Exercise of a Put Option on a Non-Dividend-Paying Stock
Problem
TableÂ€20.2 lists the quotes from the CBOE on October 5, 2015, for options on Alphabet stock
(Google’s holding company) expiring in November 2015. Alphabet will not pay a dividend dur-
ing this period. Identify any option for which exercising the option early is better than selling it.
Solution
Because Alphabet pays no dividends during the life of these options (October 2015 to November
2015), it should not be optimal to exercise the call options early. In fact, we can check that the
bid price for each call option exceeds that option’s intrinsic value, so it would be better to sell the
call than to exercise it. For example, the payoff from exercising a call with a strike of 620 early is
667.50 - 620 = $47.50, while the option can be sold for $59.10.
On the other hand, an Alphabet shareholder holding a put option with a strike price of $795
or higher would be better off exercising—rather than selling—the option. For example, by exer-
cising the 805 put the shareholder would receive $805 for her stock, whereas by selling the stock
and the option she would only receive $667.15 + 127.50 = $794.65. The same is not true of
the puts with strikes below $795, however. For example, the holder of the 750 put option who
exercises it early would receive $750 for her stock, but would net $667.15 + 86.50 = $753.65
by selling the stock and the put instead. Thus, early exercise is only optimal for the deep in-the-
money put options.7
7
Selling versus exercising may have different tax consequences or transaction costs for some investors, which could also
affect this decision.
20.5â•‡ Exercising Options Early 775
Table 20.2 Alphabet Option Quotes
GOOGL (ALPHABET INC (A)) 667.35 10.36

Oct 05 2015 @ 13:40 ET Bid 667.15 Ask 667.5 Size 1 1 Vol 1111445
Open Open
Calls Bid Ask Puts Bid Ask
Int Int
15 Nov 620.00 (GOOGL1520K620) 59.10 62.00 237 15 Nov 620.00 (GOOGL1520W620) 13.20 14.10 167
Dividend-Paying Stocks
When stocks pay dividends, the right to exercise an option on them early is generally valu-
able for both calls and puts. To see why, let’s write out the put-call parity relationship for
a dividend-paying stock:
C=S-K
¸˚˚˚˝˚˚˚˛ + dis(K ) + P - PV(Div)
¸˚˚˚˚˝˚˚˚˚˛ (20.7)
If PV(Div) is large enough, the time value of a European call option can be negative,
implying that its price could be less than its intrinsic value. Because an American option
can never be worth less than its intrinsic value, the price of the American option can exceed
the price of a European option.
To understand when it is optimal to exercise the American call option early, note that
when a company pays a dividend, investors expect the price of the stock to drop to reflect
the cash paid out. This price drop hurts the owner of a call option because the stock price
falls, but unlike the owner of the stock, the option holder does not get the dividend as
compensation. However, by exercising early, the owner of the call option can capture the
value of the dividend. Thus, the decision to exercise early trades off the benefits of wait-
ing to exercise the call option versus the loss of the dividend. Because a call should only
be exercised early to capture the dividend, it will only be optimal to do so just before the
stock’s ex-dividend date.
Dividends have the opposite effect on the time value of a put option. Again, from the
put-call parity relation, we can write the put value as:
P=K-S + C - dis(K ) + PV(Div) (20.8)

¸˚˚˚˝˚˚˚˛ ¸˚˚˚˚˝˚˚˚˚˛
Intuitively, when a stock pays dividends, the holder of a put option will benefit by waiting
for the stock price to drop after it goes ex-dividend before exercising. Thus, it is less likely
that a put option on a dividend-paying stock will be exercised early.
Example 20.10 Early Exercise of Options on a Dividend-Paying Stock
Problem
General Electric (GE) stock went ex-dividend on December 22, 2005 (only equity holders on
the previous day are entitled to the dividend). The dividend amount was $0.25. TableÂ€20.3 lists
the quotes for GE options on December 21, 2005. From the quotes, identify the options that
should be exercised early rather than sold.
Solution
The holder of a call option on GE stock with a strike price of $32.50 or less is better off exercis-
ing—rather than selling—the option. For example, exercising the 06 January 10 call and imme-
diately selling the stock would net 35.52 - 10 = $25.52. The option itself can be sold for
$25.40, so the holder is better off by $0.12 by exercising the call rather than selling it. To under-
stand why early exercise can be optimal in this case, note that interest rates were about 0.33% per
month, so the value of delaying payment of the $10 strike price until January was worth only
$0.033, and the put option was worth less than $0.05. Thus, from Eq. 20.7, the benefit of delay
was much less than the $0.25 value of the dividend.8
On the other hand, all of the put options listed have a positive time value and thus should not
be exercised early. In this case, waiting for the stock to go ex-dividend is more valuable than the
cost of delaying the receipt of the strike price.
Although most traded options are American, options on stock indices, such as the S&P
500, are typically European. TableÂ€20.4 shows quotes for European calls and puts on the
S&P 500 index, together with their intrinsic values. At the time of these quotes, the aggre-
gate dividend yield was approximately 2.8% while interest rates were 1.6% for the matu-
rity of the options. Because these are European-style options, it is possible for the option’s
Table 20.3 Option Quotes for GE on December 21, 2005 (GE paid $0.25 dividend
with ex-dividend date of December 22, 2005)
GE 35.52 0.02
Dec 21, 2005 @ 11:50 ET Vol 8103000
Open Open
Interest Interest
06 Jan 10.00 (GE AB-E) 25.40 25.60 738 06 Jan 10.00 (GE MB-E) 0 0.05 12525
06 Jan 20.00 (GE AD-E) 15.40 15.60 1090 06 Jan 20.00 (GE MD-E) 0 0.05 8501
06 Jan 25.00 (GE AE-E) 10.40 10.60 29592 06 Jan 25.00 (GE ME-E) 0 0.05 36948
06 Jan 30.00 (GE AF-E) 5.40 5.60 37746 06 Jan 30.00 (GE MF-E) 0 0.05 139548
06 Jan 32.50 (GE AZ-E) 2.95 3.10 13630 06 Jan 32.50 (GE MZ-E) 0 0.05 69047
06 Jan 35.00 (GE AG-E) 0.70 0.75 146682 06 Jan 35.00 (GE MG-E) 0.30 0.35 140014
06 Jan 40.00 (GE AH-E) 0 0.05 84366 06 Jan 40.00 (GE MH-E) 4.70 4.80 4316
06 Jan 45.00 (GE AI-E) 0 0.05 7554 06 Jan 45.00 (GE MI-E) 9.70 9.80 767
06 Jan 50.00 (GE AJ-E) 0 0.05 17836 06 Jan 50.00 (GE MJ-E) 14.70 14.80 383
06 Jan 60.00 (GE AL-E) 0 0.05 7166 06 Jan 60.00 (GE ML-E) 24.70 24.80 413
8
Again, we have analyzed the early exercise decision ignoring taxes. Some investors may face higher taxes if they exercise
the option early rather than sell or hold it.
20.6â•‡ Options and Corporate Finance 777
Table 20.4 Two-Year Call and Put Options on the S&P 500 Index
SPX 879.56 1.47

JUL 08 2009 @16:25ET
Intrinsic Intrinsic
Value Value
11 Dec 200.00 (SZD-LH-E) 632.5 638.2 679.56 11 Dec 200.00 (SZD-XH-E) 2.20 3.40 0.00
11 Dec 400.00 (SZD-LP-E) 454.9 461.3 479.56 11 Dec 400.00 (SZD-XP-E) 14.7 19.0 0.00
11 Dec 600.00 (SZJ-LR-E) 299.3 306.0 279.56 11 Dec 600.00 (SZJ-XR-E) 53.5 59.3 0.00
11 Dec 800.00 (SZJ-LL-E) 172.2 179.2 79.56 11 Dec 800.00 (SZJ-XL-E) 118.7 125.4 0.00
11 Dec 1000.00 (SZT-LR-E) 82.0 88.7 0.00 11 Dec 1000.00 (SZT-XR-E) 220.1 227.5 120.44
11 Dec 1200.00 (SZT-LU-E) 30.5 36.5 0.00 11 Dec 1200.00 (SZT-XU-E) 360.4 367.9 320.44
11 Dec 1400.00 (SZT-LA-E) 8.60 11.8 0.00 11 Dec 1400.00 (SZT-XA-E) 530.5 537.7 520.44
11 Dec 1600.00 (SZV-LO-E) 2.20 3.40 0.00 11 Dec 1600.00 (SZV-XO-E) 716.5 721.8 720.44
11 Dec 1800.00 (SZV-LD-E) 0.00 1.15 0.00 11 Dec 1800.00 (SZV-XD-E) 907.6 912.0 920.44
11 Dec 2000.00 (SZV-LE-E) 0.00 0.65 0.00 11 Dec 2000.00 (SZV-XE-E) 1099.9 1103.9 1120.44
price to be below its intrinsic value, so that its time value is negative. As the table shows,
this occurs for calls with strikes of 400 or below and for puts with strikes of 1600 or above.
For the deep in-the-money calls, the present value of the dividends is larger than the inter-
est earned on the low strike prices, making it costly to wait to exercise the option. For the
deep in-the-money puts, the interest on the high strike prices exceeds the dividends earned,
again making it costly to wait.
Concept Check 1. Is it ever optimal to exercise an American call on a non-dividend paying stock early?
2. When might it be optimal to exercise an American put option early?
3. When might it be optimal to exercise an American call early?
20.6 Options and Corporate Finance

Although we will delay much of the discussion of how corporations use options until after
we have explained how to value an option, one very important corporate application does
not require understanding how to price options: interpreting the capital structure of the
firm as options on the firm’s assets. We begin by explaining why we can think of equity as
an option.
Equity as a Call Option

Think of a share of stock as a call option on the assets of the firm with a strike price equal
to the value of debt outstanding.9 To illustrate, consider a single-period world in which at
the end of the period the firm is liquidated. If the firm’s value does not exceed the value of
debt outstanding at the end of the period, the firm must declare bankruptcy and the equity
9
Fischer Black and Myron Scholes discussed this insight in their path-breaking option valuation paper,
“The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81 (1973): 637–654.
Figure 20.8â•‡
200
Equity as a Call Option

Firm Assets
If the value of the firm’s
assets exceeds the required 150
debt payment, the equity
holders receive the value
Value ($)
that remains after the debt 100
is repaid; otherwise, the firm
is bankrupt and its equity is
Required Equity
worthless. Thus, the payoff
to equity is equivalent to 50 Debt
Payment
a call option on the firm’s
assets with a strike price
equal to the required debt
payment. 0 50 100 150 200
Firm Asset Value ($)
holders receive nothing. Conversely, if the value exceeds the value of debt outstanding, the
equity holders get whatever is left once the debt has been repaid. FigureÂ€20.8 illustrates this
payoff. Note how the payoff to equity looks exactly the same as the payoff of a call option.
Debt as an Option Portfolio

We can also represent debt using options. In this case, you can think of the debt holders as
owning the firm and having sold a call option with a strike price equal to the required debt
payment. If the value of the firm exceeds the required debt payment, the call will be exer-
cised; the debt holders will therefore receive the strike price (the required debt payment)
and “give up” the firm. If the value of the firm does not exceed the required debt payment,
the call will be worthless, the firm will declare bankruptcy, and the debt holders will be
entitled to the firm’s assets. FigureÂ€20.9 illustrates this payoff.
There is also another way to view corporate debt: as a portfolio of risk-free debt and a
short position in a put option on the firm’s assets with a strike price equal to the required
debt payment:
Risky debt = Risk@free debt - Put option on firm assets (20.9)
When the firm’s assets are worth less than the required debt payment, the put is in-the-
money; the owner of the put option will therefore exercise the option and receive the dif-
ference between the required debt payment and the firm’s asset value (see FigureÂ€20.9).
This leaves the portfolio holder (debt holder) with just the assets of the firm. If the firm’s
value is greater than the required debt payment, the put is worthless, leaving the portfolio
holder with the required debt payment.
Credit Default Swaps

By rearranging Equation 20.9, notice that we can eliminate a bond’s credit risk by buying
the very same put option to protect or insure it:
Risk@free debt = Risky debt + Put option on firm assets
Figure 20.9â•‡
200
Debt as an Option
Firm Assets
Portfolio
If the value of the firm’s 150
assets exceeds the required
debt payment, debt holders
Less: Equity Call Option
are fully repaid. Otherwise,
Value ($)
the firm is bankrupt and the Risk-Free Bond
100
debt holders receive the Debt
value of the assets. Note
Less: Put Option
that the payoff to debt
(orange line) can be viewed Required
either as (1) the firm’s 50 Debt
Payment
assets, less the equity call
option, or (2) a risk-free
bond, less a put option on
the assets with a strike price 0 50 100 150 200
equal to the required debt
Firm Asset Value ($)
payment.
We refer to this put option, which can insure a firm’s credit risk, as a credit default swap
(or CDS). In a credit default swap, the buyer pays a premium to the seller (often in the
form of periodic payments) and receives a payment from the seller to make up for the loss
if the underlying bond defaults.
Investment banks developed and began trading CDSs in the late 1990s as a means to
allow bond investors to insure the credit risk of the bonds in their portfolios. Many hedge
funds and other investors soon began using these contracts as a means to speculate on the
prospects of a firm and its likelihood of default even if they did not hold its bonds. By
late 2007, credit default swaps on over $45 trillion worth of bonds were outstanding—an
amount far larger than the total size of the corporate bond market (about $6 trillion).
While this market’s large size is impressive, it is also misleading: Because CDSs are
contracts written between counterparties, a buyer of a contract who wants to unwind
the position cannot simply sell the contract on an exchange like a standard stock option.
Global Financial Crisis Credit Default Swaps
Ironically, in the wake of the 2008 financial crisis the CDS contracts, as well as provided for trading through a central
market itself became a critical source of credit risk of concern clearing house that acts as a counterparty to all trades. To
to regulators. American International Group (AIG) required protect itself against counterparty default, the clearing house
a federal bailout in excess of $100 billion due to (1) losses would impose strict margin requirements. In addition to
on CDS protection it had sold, and (2) concern that if it improving transparency, this process allows contracts that
defaulted on paying this insurance, banks and other firms offset each other to be cancelled rather than simply offset,
who had purchased this insurance to hedge their own expo- which should help reduce the creation of new credit risk by
sures would default as well. To reduce these systemic risks the very market designed to help control it!
in the future, regulators have moved to standardize CDS
Instead, the buyer must enter a new offsetting CDS contract with a possibly new counter-
party (e.g., a buyer of insurance on GE could then sell insurance on GE to someone else,
leaving no net exposure to GE). In this way, a new contract is created with each trade, even
if investors’ net exposure is not increased. For example, when Lehman Brothers defaulted
in September 2009, buyers of CDS protection against such a default were owed close to
$400 billion. However, after netting all offsetting positions, only about $7 billion actually
changed hands.
Pricing Risky Debt

Viewing debt as an option portfolio is useful, as it provides insight into how credit spreads
for risky debt are determined. Let’s illustrate with an example.
Example 20.11 Calculating the Yield on New Corporate Debt
Problem
As of September 2012, Google (GOOG) had no debt. Suppose the firm’s managers consider
recapitalizing the firm by issuing zero-coupon debt with a face value of $163.5 billion due in
January of 2014, and using the proceeds to pay a special dividend. Suppose too that Google
had 327 million shares outstanding, trading at $700.77 per share, implying a market value of
$229.2 billion. The risk-free rate over this horizon is 0.25%. Using the call option quotes in
FigureÂ€20.10, estimate the credit spread Google would have to pay on the debt assuming perfect
capital markets.
Solution
Assuming perfect capital markets, the total value of Google’s equity and debt should remain
unchanged after the recapitalization. The $163.5 billion face value of the debt is equivalent
to a claim of $163.5 billion/(327 million shares) = $500 per share on Google’s current assets.
Because Google’s shareholders will only receive the value in excess of this debt claim, the value
of Google’s equity after the recap is equivalent to the current value of a call option with a strike
price of $500. From the quotes in FigureÂ€ 20.10, such a call option has a value of approxi-
mately $222.05 per share (using the average of the bid and ask quotes). Multiplying by Google’s
total number of shares, we can estimate the total value of Google’s equity after the recap as
$222.05 * 327 million shares = $72.6 billion.
To estimate the value of the new debt, we can subtract the estimated equity value from
Google’s total value of $229.2 billion; thus, the estimated debt value is 229.2 - 72.6 = $156.6
billion. Because the debt matures 16 months from the date of the quotes, this value corresponds
to a yield to maturity of
163.5 12/16
a b - 1 = 3.29%
156.6
Thus, Google’s credit spread for the new debt issue would be about 3.29% - 0.25% = 3.04%.
Using the methodology in Example 20.11, FigureÂ€20.10 plots this yield on Google debt
as a function of the amount borrowed and illustrates the relation between the amount bor-
rowed and the yield. The analysis in this example demonstrates the use of option valuation
methods to assess credit risk and value risky debt. While here we used data from option
quotes, in the next chapter we will develop methods to value options as well as risky debt
and other distress costs based on firm fundamentals.
Figure 20.10 Google Call Option Quotes and Implied Debt Yields
GOOG (GOOGLE INC) 700.77 5.38

Sep 10 2012 @ 21:39 ET Vol 2560067
12%
Open
Calls Bid Ask Int 10%
14 Jan 300.00 (GOOG1418A300-E) 402.90 405.90 4

8%
14 Jan 350.00 (GOOG1418A350-E) 355.30 358.00 34
Debt Yield
14 Jan 400.00 (GOOG1418A400-E) 308.20 311.60 471
6%
14 Jan 450.00 (GOOG1418A450-E) 263.00 266.50 25
14 Jan 500.00 (GOOG1418A500-E) 220.20 223.90 229
14 Jan 550.00 (GOOG1418A550-E) 181.00 184.70 122 4%
14 Jan 600.00 (GOOG1418A600-E) 145.20 148.60 303
14 Jan 650.00 (GOOG1418A650-E) 114.30 117.30 292 2%
14 Jan 660.00 (GOOG1418A660-E) 108.50 111.60 63
14 Jan 680.00 (GOOG1418A680-E) 97.80 101.70 91
0%
14 Jan 700.00 (GOOG1418A700-E) 87.60 91.00 508 100 120 140 160 180 200
14 Jan 750.00 (GOOG1418A750-E) 66.20 68.10 534 Amount Borrowed ($ Billion)
Given the CBOE call option quotes for Google stock, we can calculate the implied debt yield given perfect
markets if Google were to borrow by issuing 16-month, zero-coupon bonds. Note the increase in the debt yield
with the amount borrowed.
Agency Conflicts
In addition to pricing, the option characterization of equity and debt securities provides
a new interpretation of the agency conflicts between debt and equity holders that we dis-
cussed in ChapterÂ€16. Recall that the price of an option generally increases with the volatil-
ity level of the underlying security. Because equity is like a call option on the firm’s assets,
equity holders will benefit from investments that increase the risk of the firm. On the other
hand, debt holders are short a put option on the firm’s assets. Thus, they will be hurt by an
increase in the firm’s risk. This conflict of interest regarding risk-taking is the asset substi-
tution problem (see SectionÂ€16.5), and we can quantify it in terms of the sensitivity of the
option values to the firm’s volatility.
Similarly, when the firm makes new investments that increase the value of the firm’s
assets, the value of a put option on the firm will decline. Because debt holders are short
a put option, the value of the firm’s debt will increase. Thus, some fraction of each dollar
increase in the value of the firm’s assets will go to debt holders, rather than equity holders,
reducing equity holders’ incentive to invest. This problem is the debt overhang problem we
discussed in SectionÂ€16.5, and we can quantify it in terms of the sensitivity of the call and
put values to the value of the firm’s underlying assets.
The usefulness of options to corporate managers is by no means limited to the appli-
cations we discuss in this section. However, to understand the other applications, and to
quantify the results we have discussed here, we need deeper knowledge of what determines
the option price. In ChapterÂ€21, we develop these tools and explore how to calculate the
price of an option.
Concept Check 1. Explain how equity can be viewed as a call option on the firm.
2. Explain how debt can be viewed as an option portfolio.
Here is what you should know after reading this chapter. will
help you identify what you know and where to go when you need to practice.
20.1â•‡ Option Basics

n A call option gives the holder the right (but not the obligation) to purchase an asset at some
future date. A put option gives the holder the right to sell an asset at some future date.
n When a holder of an option enforces the agreement and buys or sells the share of stock at the
agreed-upon price, the holder is exercising the option.
n The price at which the holder agrees to buy or sell the share of stock when the option is exer-
cised is called the strike price or exercise price.
n The last date on which the holder has the right to exercise the option is known as the expiration
date.
n An American option can be exercised on any date up to, and including, the exercise date. A
European option can be exercised only on the expiration date.
n If the payoff from exercising the option immediately is positive, the option is in-the-money.
If the stock price equals the strike price, the option is at-the-money. Finally, if you would lose
money by exercising an option immediately, the option is out-of-the-money.
20.2â•‡ Option Payoffs at Expiration

n Given stock price S and strike price K, the value of a call option at expiration is
C = max (S - K, 0) (20.1)
n The value of a put option at expiration is
P = max (K - S, 0) (20.2)
n An investor holding a short position in an option has an obligation; he or she takes the opposite
side of the contract to the investor who is long.
n The value an option would have if it expired today is its intrinsic value. The time value of an
option is the difference between its current value and its intrinsic value.
20.3â•‡ Put-Call Parity

n Put-call parity relates the value of the European call to the value of the European put and the
stock.
C = P + S - PV(K ) - PV(Div) (20.4)
20.4â•‡ Factors Affecting Option Prices

n Call options with lower strike prices are more valuable than otherwise identical calls with higher
strike prices. Conversely, put options are more valuable with higher strike prices.
n Call options increase in value, and put options decrease in value, when the stock price rises.
n Arbitrage bounds for option prices:
n An American option cannot be worth less than its European counterpart.
n A put option cannot be worth more than its exercise price.
n A call option cannot be worth more than the stock itself.
n An American option cannot be worth less than its intrinsic value.
n An American option with a later exercise date cannot be worth less than an otherwise identi-
cal American option with an earlier exercise date.

n The value of an option generally increases with the volatility of the stock.
Problems˘ ï»¿ 783
20.5â•‡Exercising Options Early

n It is never optimal to exercise an American call option on a non-dividend-paying stock early.
Thus, an American call option on a non-dividend-paying stock has the same price as its Euro-
pean counterpart.
n It can be optimal to exercise a deep in-the-money American put option. It can be optimal to
exercise an American call option just before the stock goes ex-dividend.
20.6â•‡ Options and Corporate Finance

n Equity can be viewed as a call option on the firm’s assets.
n The debt holders can be viewed as owning the firm’s assets and having sold a call option with a
strike price equal to the required debt payment.
n Alternatively, corporate debt is a portfolio of riskless debt and a short position in a put option
on the firm’s cash flow with a strike price equal to the required debt payment. This put option
is also referred to as a credit default swap.
n Option valuations can be used to estimate the appropriate yield for risky debt, as well as to
estimate the magnitude of agency cost problems within the firm.
Key Terms American options p. 757 open interest p. 758

at-the-money p. 758 option premium p. 757
butterfly spread p. 767 option writer p. 757
call option p. 757 out-of-the-money p. 759
credit default swap (CDS) p. 779 portfolio insurance p. 767
deep in-the-money p. 759 protective put p. 767
deep out-of-the-money p. 759 put option p. 757
European options p. 757 put-call parity p. 769
exercising (an option) p. 757 speculate p. 759
expiration date p. 757 straddle p. 766
financial option p. 757 strangle p. 766
hedging p. 759 strike (exercise) price p. 757
in-the-money p. 759 time value p. 771
intrinsic value p. 771
Further For a deeper discussion of options and other derivative securities, see the following books:
R. McDonald, Derivative Markets (Prentice Hall, 2009); and J. Hull, Options, Futures, and Other
Reading Derivatives (Prentice Hall, 2011).
Problems All problems are available in . An asterisk (â•›*) indicates problems with a higher level of
difficulty.
Option Basics
1. Explain the meanings of the following financial terms:
a. Option
b. Expiration date
c. Strike price
d. Call
e. Put
2. What is the difference between a European option and an American option? Are European options
available exclusively in Europe and American options available exclusively in the United States?
3. Below is an option quote on IBM from the CBOE Web site showing options expiring in Octo-
ber and November 2015.
a. Which option contract had the most trades on that day?
b. Which option contract is being held the most overall?
c. Suppose you purchase one option with symbol IBM1516J150. How much will you need to
pay your broker for the option (ignoring commissions)?
d. Explain why the last sale price is not always between the bid and ask prices.
e. Suppose you sell one option with symbol IBM1516V150. How much will you receive for
the option (ignoring commissions)?
f. The calls with which strike prices are currently in-the-money? Which puts are in-the-money?
g. What is the difference between the option with symbol IBM1516J140 and the option with
symbol IBM1506K140?
h. On what date does the option with symbol IBM1516V140 expire? In what range must
IBM’s stock price be at expiration for this option to be valuable?
IBM (INTL BUSINESS MACHINES) 149.04 4.46

Oct 05 2015 @ 16:39 ET Bid 148.72 Ask 149.04 Size 3 3 Vol 4997840
Last Open Last Open

Calls Sale Net Bid Ask Vol Int Puts Sale Net Bid Ask Vol Int
15 Oct 140.00 (IBM1516J140) 9.55 4.10 9.15 9.50 35 390 15 Oct 140.00 (IBM1516V140) 0.36 −0.62 0.35 0.36 834 3762
15 Oct 145.00 (IBM1516J145) 4.95 2.86 4.80 5.20 234 1689 15 Oct 145.00 (IBM1516V145) 0.89 −1.30 0.86 0.87 855 2395
15 Oct 150.00 (IBM1516J150) 1.50 1.13 1.53 1.54 786 3380 15 Oct 150.00 (IBM1516V150) 2.44 −3.62 2.24 2.47 180 2774
15 Oct 155.00 (IBM1516J155) 0.23 0.19 0.18 0.19 662 4569 15 Oct 155.00 (IBM1516V155) 6.01 −5.99 5.60 6.30 81 2985
15 Nov 140.00 (IBM1506K140) 6.77 0 10.45 11.05 0 73 15 Nov 140.00 (IBM1506W140) 1.76 −1.64 1.93 2.00 34 54
15 Nov 145.00 (IBM1506K145) 5.83 1.58 6.70 6.90 94 191 15 Nov 145.00 (IBM1506W145) 3.00 −2.69 3.20 3.35 33 78
15 Nov 150.00 (IBM1506K150) 3.86 1.84 3.65 3.85 314 43 15 Nov 150.00 (IBM1506W150) 8.66 0 5.40 5.55 0 11
15 Nov 155.00 (IBM1506K155) 1.72 0.90 1.67 1.74 135 123 15 Nov 155.00 (IBM1506W155) 8.30 0 7.85 8.80 2 0
Option Payoffs at Expiration

4. Explain the difference between a long position in a put and a short position in a call.
5. Which of the following positions benefit if the stock price increases?
a. Long position in a call
b. Short position in a call
c. Long position in a put
d. Short position in a put
6. You own a call option on Intuit stock with a strike price of $36. The option will expire in
exactly three months’ time.
a. If the stock is trading at $46 in three months, what will be the payoff of the call?
b. If the stock is trading at $32 in three months, what will be the payoff of the call?
c. Draw a payoff diagram showing the value of the call at expiration as a function of the stock
price at expiration.
7. Assume that you have shorted the call option in Problem 6.
a. If the stock is trading at $46 in three months, what will you owe?
b. If the stock is trading at $32 in three months, what will you owe?
c. Draw a payoff diagram showing the amount you owe at expiration as a function of the stock
8. You own a put option on Ford stock with a strike price of $8. The option will expire in exactly
six months’ time.
a. If the stock is trading at $2 in six months, what will be the payoff of the put?
b. If the stock is trading at $21 in six months, what will be the payoff of the put?
c. Draw a payoff diagram showing the value of the put at expiration as a function of the stock
Problems˘ ï»¿ 785
9. Assume you have shorted the put option in Problem 8.

a. If the stock is trading at $2 in three months, what will you owe?
b. If the stock is trading at $21 in three months, what will you owe?
c. Draw a payoff diagram showing the amount you owe at expiration as a function of the stock
10. What position has more downside exposure: a short position in a call or a short position in a
put? That is, in the worst case, in which of these two positions would your losses be greater?
11. Consider the October 2015 IBM call and put options in Problem 3. Ignoring any interest you
might earn over the remaining few days’ life of the options:
a. Compute the break-even IBM stock price for each option (i.e., the stock price at which your
total profit from buying and then exercising the option would be zero).
b. Which call option is most likely to have a return of - 100%?
c. If IBM’s stock price is $156 on the expiration day, which option will have the highest return?
12. You are long both a call and a put on the same share of stock with the same exercise date. The
exercise price of the call is $40 and the exercise price of the put is $45. Plot the value of this
combination as a function of the stock price on the exercise date.
13. You are long two calls on the same share of stock with the same exercise date. The exercise price
of the first call is $40 and the exercise price of the second call is $60. In addition, you are short
two otherwise identical calls, both with an exercise price of $50. Plot the value of this combina-
tion as a function of the stock price on the exercise date. What is the name of this combination
of options?
*14. A forward contract is a contract to purchase an asset at a fixed price on a particular date in the
future. Both parties are obligated to fulfill the contract. Explain how to construct a forward
contract on a share of stock from a position in options.
15. You own a share of Costco stock. You are worried that its price will fall and would like to insure
yourself against this possibility. How can you purchase insurance against this possibility?
16. It is October 5, 2015, and you own IBM stock. You would like to insure that the value of your
holdings will not fall significantly. Using the data in Problem 3, and expressing your answer in
terms of a percentage of the current value of your portfolio:
a. What will it cost to insure that the value of your holdings will not fall below $140 per share
between now and the third Friday in October?
b. What will it cost to insure that the value of your holdings will not fall below $140 per share
between now and the third Friday in November?
c. What will it cost to insure that the value of your holdings will not fall below $145 per share
between now and the third Friday in November?
Put-Call Parity
17. Dynamic Energy Systems stock is currently trading for $32 per share. The stock pays no divi-
dends. A one-year European put option on Dynamic with a strike price of $41 is currently
trading for $9.18. If the risk-free interest rate is 10% per year, what is the price of a one-year
European call option on Dynamic with a strike price of $41?
18. You happen to be checking the newspaper and notice an arbitrage opportunity. The current
stock price of Intrawest is $20 per share and the one-year risk-free interest rate is 8%. A one-
year put on Intrawest with a strike price of $18 sells for $3.33, while the identical call sells for
$7. Explain what you must do to exploit this arbitrage opportunity.
19. Consider the October 2015 IBM call and put options in Problem 3. Ignoring the negligible inter-
est you might earn on T-bills over the remaining few days’ life of the options, show that there is no
arbitrage opportunity using put-call parity for the options with a $140 strike price. Specifically:
a. What is your profit/loss if you buy a call and T-bills, and sell IBM stock and a put option?
b. What is your profit/loss if you buy IBM stock and a put option, and sell a call and T-bills?
c. Explain why your answers to (a) and (b) are not both zero.
M20_BERK0160_04_GE_C20.indd 785 8/20/16 11:52 AM

d. Do the same calculation for the October options with a strike price of $150. What do you
find? How can you explain this?
20. In mid-February 2016, European-style options on the S&P 100 index (OEX) expiring in
December 2017 were priced as follows:
Dec 2017 OEX Index Options

Strike Price Call Price Put Price
840 88.00
860 76.30 102.21
880 111.56
Given an interest rate of 0.40% for a December 2017 maturity (22 months in the future), use
put-call parity (with dividends) to determine:
a. The price of a December 2017 OEX put option with a strike price of 840.
b. The price of a December 2017 OEX call option with a strike price of 880.
Factors Affecting Option Prices

21. Suppose Amazon stock is trading for $780 per share, and Amazon pays no dividends.
a. What is the maximum possible price of a call option on Amazon?
b. What is the maximum possible price of a put option on Amazon with a strike price of $940?
c. What is the minimum possible value of a call option on Amazon stock with a strike price of
$600?
d. What is the minimum possible value of an American put option on Amazon stock with a
strike price of $910?
22. Consider the data for IBM options in Problem 3. Suppose a new American-style put option on
IBM is issued with a strike price of $155 and an expiration date of November 1st.
a. What is the maximum possible price for this option?
b. What is the minimum possible price for this option?
23. You are watching the option quotes for your favorite stock, when suddenly there is a news
announcement. Explain what type of news would lead to the following effects:
a. Call prices increase, and put prices fall.
b. Call prices fall, and put prices increase.
c. Both call and put prices increase.
Exercising Options Early

*24. Explain why an American call option on a non-dividend-paying stock always has the same price
as its European counterpart.
25. Consider an American put option on XAL stock with a strike price of $49 and one year to expi-
ration. Assume XAL pays no dividends, it is currently trading for $8 per share, and the one-year
interest rate is 8%. If it is optimal to exercise this option early:
a. What is the price of a one-year American put option on XAL stock with a strike price of $63
per share?
b. What is the maximum price of a one-year American call option on XAL stock with a strike
price of $49 per share?
M20_BERK0160_04_GE_C20.indd 786 8/20/16 11:52 AM

Problems 787
26. The stock of Harford Inc. is about to pay a $0.22 dividend. It will pay no more dividends for
the next month. Consider call options that expire in one month. If the interest rate is 5% APR
(monthly compounding), what is the maximum strike price where it could be possible that
early exercise of the call option is optimal? (Round to the nearest dollar.)
27. Suppose the S&P 500 is at 899, and a one-year European call option with a strike price of $428
has a negative time value. If the interest rate is 6%, what can you conclude about the dividend
yield of the S&P 500? (Assume all dividends are paid at the end of the year.)
28. Suppose the S&P 500 is at 899, and it will pay a dividend of $27 at the end of the year. Suppose
also that the interest rate is 3%. If a one-year European put option has a negative time value,
what is the lowest possible strike price it could have?
Options and Corporate Finance

29. Wesley Corp. stock is trading for $24 per share. Wesley has 24 million shares outstanding and a
market debt-equity ratio of 0.44. Wesley’s debt is zero-coupon debt with a 5-year maturity and
a yield to maturity of 10%.
a. Describe Wesley’s equity as a call option. What is the maturity of the call option? What is the
market value of the asset underlying this call option? What is the strike price of this call option?
b. Describe Wesley’s debt using a call option.
c. Describe Wesley’s debt using a put option.
*30. Express the position of an equity holder in terms of put options.
31. Use the option data from July 13, 2009 in the following table to determine the rate Google
would have paid if it had issued $101.89 billion in zero-coupon debt due in January 2011.
Suppose Google currently had 318.41 million shares outstanding, implying a market value of
$134.22 billion. (Assume perfect capital markets.)
GOOG 422.27 7.87

Jul 13 2009 @ 13:10 ET Vol 2177516
Open
Calls Bid Ask Int
11 Jan 150.0 (OZF AJ) 273.60 276.90 100

11 Jan 160.0 (OZF AL) 264.50 267.20 82
11 Jan 200.0 (OZF AA) 228.90 231.20 172
11 Jan 250.0 (OZF AU) 186.50 188.80 103
11 Jan 280.0 (OZF AX) 162.80 165.00 98
11 Jan 300.0 (OZF AT) 148.20 150.10 408
11 Jan 320.0 (OZF AD) 133.90 135.90 63
11 Jan 340.0 (OZF AI) 120.50 122.60 99
11 Jan 350.0 (OZF AK) 114.10 116.10 269
11 Jan 360.0 (OZF AM) 107.90 110.00 66
11 Jan 380.0 (OZF AZ) 95.80 98.00 88
11 Jan 400.0 (OZF AU) 85.10 87.00 2577
11 Jan 420.0 (OUP AG) 74.60 76.90 66
11 Jan 450.0 (OUP AV) 61.80 63.30 379
*32. Suppose that in July 2009, Google were to issue $96 billion in zero-coupon senior debt, and
another $26 billion in zero-coupon junior debt, both due in January 2011. Use the option
data in the preceding table to determine the rate Google would pay on the junior debt issue.
(Assume perfect capital markets.)
M20_BERK0160_04_GE_C20.indd 787 8/20/16 11:52 AM

Data Case Your uncle owns 10,000 shares of Walmart stock. He is concerned about the short-term outlook
for Walmart’s stock due to an impending “major announcement.” This announcement has received
much attention in the press so he expects the stock price will change significantly in the next month,
but is unsure whether it will be a profit or a loss. He hopes the price will increase, but he also doesn’t
want to suffer if the price were to fall in the short term.
His broker recommended he buy a “protective put” on the stock, but your uncle has never traded
options before and is not much of a risk taker. He wants you to devise a plan for him to capitalize if
the announcement is positive but to still be protected if the news causes the price to drop. You real-
ize that a protective put will protect him from the downside risk, but you think a straddle may offer
similar downside protection, while increasing the upside potential. You decide to show him both
strategies and the resulting profits and returns he could face from each.
1. Download option quotes on options that expire in approximately one month on Walmart from
the Chicago Board Options Exchange (www.cboe.com) into an Excel spreadsheet (click the
Quotes & Data tab at the top left portion of the screen and then select “Delayed Quotes”). If you
choose to download “near term at-the-money” options you will get a range of options expiring in
about a month. Note: You can only get active quotes while the exchange is open; bid or ask prices
are not available when it is closed.
2. Determine your uncle’s profit and return using the protective put.
a. Identify the expiring put with an exercise price closest to, but not below, the current stock
price. Determine the investment required to protect all 10,000 shares.
b. Determine the put price at expiration for each stock price at $5 increments within a range of
$40 of Walmart’s current price using Eq. 20.2.
c. Compute the profit (or loss) on the put for each stock price used in part (b).
d. Compute the profit on the stock from the current price for each stock price used in part (b).
e. Compute his overall profit (or loss) of the protective put, that is, combining the put and his
stock for each price used in parts (c) and (d).
f. Compute the overall return of the protective put.
3. Determine your uncle’s profit and return using the straddle.
a. Compute the investment your uncle would have to make to purchase the call and put with the
same exercise price and expiration as the put option in Question 2, to cover all 10,000 of his shares.
b. Determine the value at expiration of the call and the put options at each $5 increment of
stock prices within a range of $40 of Walmart’s current price using Eqs. 20.1 and 20.2.
c. Determine the profit (or loss) on the options at each stock price used in part (b).
d. Determine the profit (or loss) on the stock from the current price for each stock price used in part (b).
e. Compute his overall profit (or loss) of the stock plus straddle, that is, combining the position
in both options and his stock for each price used in parts (c) and (d).
f. Compute the overall return of this position.
4. Was the broker correct that the protective put would prevent your uncle from losing if the
announcement caused a large decrease in the stock value? What is your uncle’s maximum possible
loss using the protective put?
5. What is the maximum possible loss your uncle could experience using the straddle?
6. Which strategy, the protective put or the straddle, provides the maximum upside potential for
your uncle? Why does this occur?
Note: Updates to this data case may be found at www.berkdemarzo.com.
C h a P t er
Option Valuation 21
rOBerT MerTON AND MYrON SChOLeS Were AWArDeD the 1997 NOtat IO n
1
Nobel Prize in economics for their 1973 discovery, together with Fischer Black, of a
shares of stock in the
formula to calculate the price of an option: the Black-Scholes Option Pricing Model. replicating portfolio;
Although the formula itself represented an enormous contribution to economics, even sensitivity of option price
to stock price
more important were the techniques that Black, Scholes, and Merton developed to
B risk-free investment in
value options. These techniques changed the course of financial economics and gave the replicating portfolio
birth to a new profession: financial engineering. Routinely, financial engineers use for- S stock price
mulas to price financial securities in much the same way as civil engineers use Newton’s rf risk-free rate of interest
laws to build bridges. The most important factor contributing to the huge growth in the C call option price
types of financial securities available in the market are the techniques used to price T years until the exercise
them, which can all be traced to the Black-Â�Scholes formula. Today, most large corpora- date of an option
tions rely on these financial securities to manage risk. Without the Black-Scholes K strike price
Â�formula, the job of corporate managers would be very different: Many Â�corporations
s volatility of stock’s return
N(dâ•›â•›) cumulative normal
would be forced to bear much more risk than they presently do.
distribution
These formulas rely primarily on the Law of One Price. That is, they do not depend ln natural logarithm
on knowing unobservable parameters such as investor tastes and beliefs. The great insight PV present value
that Black, Â�Scholes, and Merton brought to economics is that in the case of options it is not P put option price
necessary to model preferences. As we will explain in this chapter, their work demonstrated S x value of stock excluding
how to apply the Law of One Price to value a vast new range of financial securities based on dividends
the current market prices of stocks and bonds.
q dividend yield
r risk-neutral probability
Our objective in this chapter is to explain the most commonly used techniques (all
bS , bB beta of the stock, bond
of which derive from Black and Scholes’ insights) for calculating the price of an option:
bE , bD beta of the levered
the Binomial Option Pricing Model, the Black-Scholes formula, and risk-neutral probabilities. equity, debt
We apply these techniques to show how to value stock options and quantify their risk bU beta of the firm’s assets;
and return. We then show how to use the Black-Scholes formula to estimate the beta of beta of unlevered equity
A, E, D market value of
assets, equity,
1 debt
The Black-Scholes formula was derived by Fischer Black and Myron Scholes (“The Pricing of
Options and Corporate Liabilities,” Journal of Political Economy 81, 1973), building on earlier
work by Robert Merton. Unfortunately, Black died two years before the prize was awarded.
789
790 Chapter 21â•‡ Option Valuation
risky debt. With this foundation in place, in subsequent chapters we will be able to cover important
applications of option pricing for corporate managers.
21.1 The Binomial Option Pricing Model

We begin our study of option pricing with the Binomial Option Pricing Model.2 The
model prices options by making the simplifying assumption that at the end of the next
period, the stock price has only two possible values. Under this assumption, we demon-
strate the key insight of Black and Scholes—that option payoffs can be replicated exactly
by constructing a portfolio out of a risk-free bond and the underlying stock. Furthermore,
we will see that the model can be quite realistic if we consider stock price movements over
very short time intervals.
A Two-State Single-Period Model

Let’s start by calculating the price of a single-period option in a very simple world. We will
value the option by first constructing a replicating portfolio, a portfolio of other securi-
ties that has exactly the same value in one period as the option. Then, because they have
the same payoffs, the Law of One Price implies that the current value of the call and the
replicating portfolio must be equal.
Consider a European call option that expires in one period and has an exercise price
of $50. Assume that the stock price today is equal to $50. Assume here and throughout
the chapter that the stock pays no dividends (unless explicitly indicated). In one period,
the stock price will either rise by $10 or fall by $10. The one-period risk-free rate is 6%.
We can summarize this information on a binomial tree—a timeline with two branches at
every date representing the possible events that could happen at those times:
0 1
Stock Bond Call
60 1.06 max (60 50, 0) 10

Stock 50
Bond 1
40 1.06 max (40 50, 0) 0
The binomial tree contains all the information we currently know: the value of the
stock, bond, and call options in each state in one period, as well as the price of the stock
and bond today (for simplicity, we assume the bond price today is $1, so in one period it
will be worth $1.06). We define the state in which the stock price goes up (to $60) as the
up state and the state in which the stock price goes down (to $40) as the down state.
In order to determine the value of the option using the Law of One Price, we must show
that we can replicate its payoffs using a portfolio of the stock and the bond. Let be the
number of shares of stock we purchase, and let B be our initial investment in bonds. To cre-
ate a call option using the stock and the bond, the value of the portfolio consisting of the
2
This technique was originally derived by J. Cox, S. Ross, and M. Rubinstein, “Option Pricing, a
Â�
Simplified Approach,” Journal of Financial Economics 7 (1979): 229–263; and J. Rendleman and
B.Â€Â�Bartter, “Two-State Option Pricing,” Journal of Finance 34 (December 1979): 1093–1110.
21.1â•‡ The Binomial Option Pricing Model 791
stock and bond must match the value of the option in every possible state. Thus, in the up
state, the value of the portfolio must be $10 (the value of the call in that state):
60 + 1.06B = 10 (21.1)
In the down state, the value of the portfolio must be zero (the value of the call in that state):
40 + 1.06B = 0 (21.2)
Equations 21.1 and 21.2 are two simultaneous equations with two unknowns, and B.
We’ll write down the general formula to solve these equations shortly, but in this case, we
can check that the solution is
= 0.5
B = - 18.8679
A portfolio that is long 0.5 share of stock and short approximately $18.87 worth of bonds
(i.e., we have borrowed $18.87 at a 6% interest rate) will have a value in one period that
matches the value of the call exactly. Let’s verify this explicitly:
60 * 0.5 - 1.06 * 18.87 = 10
40 * 0.5 - 1.06 * 18.87 = 0
Therefore, by the Law of One Price, the price of the call option today must equal the cur-
rent market value of the replicating portfolio. The value of the portfolio today is the value
of 0.5 shares at the current share price of $50, less the amount borrowed:
50 + B = 50(0.5) - 18.87 = 6.13 (21.3)
3
Thus, the price of the call today is $6.13.
FigureÂ€ 21.1 illustrates how we can use the stock and the bond to replicate the
Â�payoff of the call option in this case. As a function of the future stock price, the pay-
off of the replicating portfolio is a line with a slope of = 0.5, and an intercept of
FV(B) = 1.06( - 18.87) = - 20. This line is very different from the line showing the Â�payoff
Figure 21.1â•‡
30
Call Option
Replicating an Option in the Binomial Model
20
The red line shows the Â�payoff of the Â�replicating
Â�portfolio and the blue line shows the Â�payoff of the
call option, as a function of next period’s stock 10
Payoff ($)
price. While they do not match Â�everywhere, they

do match for the two Â�possible Â�outcomes of the 10 20 30 40 50 60 70 80
0
stock price next period, $40 and $60.
10
Replicating Portfolio
20
Stock Price Next Period ($)
3
If the call’s price were different, say $6.50, there would be an arbitrage opportunity: we could earn a
profit by buying the replicating portfolio for $6.13 and selling the call for $6.50. Because they have the
same payoff, we have taken no risk, and earn an immediate profit of 6.50 - 6.13 = $0.37 per option.
of the call option, which is zero below the strike price of $50 and increases 1:1 with the
stock price above $50. The secret of the binomial model is that while the option and the
replicating portfolio do not have the same payoffs in general, they have the same payoffs
given the only two outcomes we have assumed possible for the stock price: $40 and $60.
Note that by using the Law of One Price, we are able to solve for the price of the option
without knowing the probabilities of the states in the binomial tree. That is, we did not need
to specify the likelihood that the stock would go up versus down. This remarkable result
was a very important discovery because the probabilities of future states are part of investor
beliefs, so they are very difficult to estimate. The preceding argument shows that we do not
need to know these probabilities to value options. It also means that we do not need to
know the expected return of the stock, which will depend on these probabilities.
The Binomial Pricing Formula

Now that we have seen the basic idea, let’s consider a more general example. Suppose the
current stock price is S, and the stock price will either go up to Su or down to Sd next
period. The risk-free interest rate is rf . Let’s determine the price of an option that has a
value of Cu if the stock goes up, and Cd if the stock goes down:
0 1
Stock Option
Su Cu
Sd Cd
Note that in the depiction of the binomial tree above, for simplicity, we did not write
down the bond payoff since it earns a return of rf in either case.
What is the value of the option today? Again, we must determine the number of shares
of stock, , and the position in the bond, B, such that the payoff of the replicating Â�portfolio
matches the payoff of the option if the stock goes up or down:
Su + (1 + rf )B = Cu and Sd + (1 + rf )B = Cd (21.4)
Solving these two equations for the two unknowns and B, we get the general formula
for the replicating formula in the binomial model:
Replicating Portfolio in the Binomial Model
C u - Cd Cd - Sd
= and B = (21.5)
S u - Sd 1 + rf
Note that the formula for in Eq. 21.5 can be interpreted as the sensitivity of the option’s
value to changes in the stock price. It is equal to the slope of the line showing the payoff of
the replicating portfolio in FigureÂ€21.1.
Once we know the replicating portfolio, we can calculate the value C of the option
today as the cost of this portfolio:
Option Price in the Binomial Model
C = S + B (21.6)
Equations 21.5 and 21.6 summarize the binomial option pricing model. Although they are
relatively simple, by applying them in different ways we will see that they are quite power-
ful. For one thing, they do not require that the option we are valuing is a call option—we
can use them to value any security whose payoff depends on the stock price. For example,
we can use them to price a put, as presented in Example 21.1.
Example 21.1 Valuing a Put Option
Problem
Suppose a stock is currently trading for $60, and in one period will either go up by 20% or fall
by 10%. If the one-period risk-free rate is 3%, what is the price of a European put option that
expires in one period and has an exercise price of $60?
Solution
We begin by constructing a binomial tree:
0 1
Stock Put
72 max (60 72, 0) 0
Stock 60
54 max (60 54, 0) 6
Thus, we can solve for the value of the put by using Eq. 21.5 and Eq. 21.6 with Cu = 0 (the
value of the put when the stock goes up) and Cd = 6 (the value of the put when the stock goes
down). Therefore,
Cu - Cd 0-6 Cd - Sd 6 - 54( - 0.3333)
= = = - 0.3333 and B = = = 23.30
Su - Sd 72 - 54 1 + rf 1.03
This portfolio is short 0.3333 shares of the stock, and has $23.30 invested in the risk-free bond.
Let’s check that it replicates the put if the stock goes up or down:
72( - 0.3333) + 1.03(23.30) = 0 and 54( - 0.3333) + 1.03(23.30) = 6
Thus, the value of the put is the initial cost of this portfolio. Using Eq. 21.6:
Put value = C = S + B
= 60( - 0.3333) + 23.30 = $3.30
You might be skeptical at this point. Showing that we can value call and put options in
a simple two-state one-period example is one thing; pricing real-world options is another
matter altogether. Yet, as we show in the next section, this simple two-state model is easily
generalized.
A Multiperiod Model
The problem with the simple two-state example is that there are many more than two
Â�possible outcomes for the stock price in the real world. To make the model more realistic,
we must allow for the possibility of many states and periods.
Let’s consider a two-period binomial tree for the stock price:4
0 1 2
60
50
40 40
30
20
The key property of the binomial model is that in each period, there are only two pos-
sible outcomes—the stock either goes up or down. But by adding an additional period, the
number of possible stock prices at the end has increased. Let’s assume again that the risk-
free rate of interest is 6% per period and consider how to price a call option with a strike
price of $50 that expires in two periods.
To calculate the value of an option in a multiperiod binomial tree, we start at the end
of the tree and work backward. At time 2, the option expires, so its value is equal to its
intrinsic value. In this case, the call will be worth $10 if the stock price goes up to $60, and
will be worth zero otherwise.
Next, let’s determine the value of the option in each possible state at time 1. What is the
value of the option if the stock price has gone up to $50 at time 1? In this case, because the
option expires next period, the remaining part of the binomial tree is as follows:
1 2
Stock Call
60 max (60 50, 0) 10
Stock 50
40 max (40 50, 0) 0
This binomial tree is exactly the same tree that we considered in the one-period model at
the start of this section. There, we computed the replicating portfolio as having = 0.5 shares
of stock and a bond position of B = - $18.87, for an initial call value of $6.13 (see Eq. 21.3).
What if the stock price has dropped to $30 at time 1? In that case, the binomial tree for
the next period is
1 2
Stock Call
40 max (40 50, 0) 0
Stock 30
20 max (20 50, 0) 0
4
The multiperiod tree is sometimes referred to as a binomial lattice.
The option is worthless in both states at time 2, so the value of the option in the down
state at time 1 must also be zero (and the replicating portfolio is simply = 0 and B = 0).
Given the value of the call option in either state at time 1, we can now work backward
and determine the value of the call at time 0. In that case, we can write the binomial tree
over the next period as follows:
0 1
Stock Call
50 6.13
Stock 40
30 0
In this case, the call values at the end of the tree (time 1) are not the final payoffs of the
option, but are the values of the option one period prior to expiration. Nonetheless,
we can use the same binomial formulas to calculate the replicating portfolio at time
0, which is a portfolio whose value will match the value of the option at time 1. From
Eq. 21.5:
Cu - Cd 6.13 - 0
= = = 0.3065 and
Su - S d 50 - 30
Cd - Sd 0 - 30(0.3065)
B= = = - 8.67
1 + rf 1.06
From Eq. 21.6, the initial value of the call option is equal to the initial cost of this
portfolio:
C = S + B = 40(0.3065) - 8.67 = $3.59
Therefore, the initial value of the call option at time 0 is $3.59.

For this two-period call option, while we can still construct the option out of the stock
and the bond, we now need to adjust our replicating portfolio at the end of each period.
That is, we start off long 0.3065 shares of stock and borrow $8.67 (for an initial cost
of $3.59). If the stock price drops to $30, our shares are worth $30 * 0.3065 = $9.20,
and our debt has grown to $8.67 * 1.06 = $9.20. Thus, the net value of the portfo-
lio is worthless (matching the option value), and we can liquidate the portfolio (at no
cost). If the stock price rises to $50, the net value of the portfolio rises to $6.13. In
that case, the new of the replicating portfolio is 0.5. Therefore, to match the new
, we buy 0.50 - 0.3065 = 0.1935 more shares of stock and pay for it by borrowing
0.1935 * $50 = $9.67. This re-trading requires no new money; at the end our total debt
will be $8.67 * 1.06 + $9.67 = $18.87, which matches the value for B we calculated ear-
lier. Finally, on the expiration date at time 2, the value of the portfolio is $10 if the stock
goes up to $60, and is zero otherwise.
The idea that you can replicate the option payoff by dynamically trading in a portfolio
of the underlying stock and a risk-free bond was one of the most important contribuÂ�-
tions of the original Black-Scholes paper. Today, this kind of replication strategy is called a
dynamic trading strategy.
Example 21.2 Using the Binomial Option Pricing Model to Value a Put Option
Problem
Suppose the current price of Narver Network Systems stock is $50 per share. In each of the next
two years, the stock price will either increase by 20% or decrease by 10%. The 3% one-year risk-
free rate of interest will remain constant. Calculate the price of a two-year European put option
on Narver Network Systems stock with a strike price $60.
Solution
Here is the binomial tree for the stock price, together with the final payoffs of the put option:
0 1 2
Stock Put
72 0
60
Stock 50 54 6
45
40.5 19.5
If the stock goes up to $60 at time 1, we are in exactly the same situation as in Example 21.1. Using
our result there, we see that if the stock is worth $60 at time 1, the value of the put option is $3.30.
If the stock goes down to $45 at time 1, then at time 2 the put option will be worth either $6
if the stock goes up or $19.50 if the stock goes down. Using Eq. 21.5:
Cu - Cd 6 - 19.5 Cd - Sd 19.5 - 40.5( - 1)
= = = - 1 and B = = = 58.25
Su - Sd 54 - 40.5 1 + rf 1.03
This portfolio is short one share of the stock, and has $58.25 invested in the risk-free bond.
Because the value of the bond will grow to $58.25 * 1.03 = $60 at time 2, the value of the
replicating portfolio will be $60 less the final price of the stock, matching the payoff of the put
option. Thus, the value of the put is the cost of this portfolio. Using Eq. 21.6:
Put value = C = S + B = 45( - 1) + 58.25 = $13.25
Now consider the value of the put option at time 0. In period 1, we have calculated that the put
will be worth $3.30 if the stock goes up to $60 and $13.25 if the stock falls to $45. The binomial
tree at time 0 is
0 1
Stock Put
60 3.30
Stock 50
45 13.25
Using Eq. 21.5 and Eq. 21.6, the replicating portfolio and put value at time 0 are
Cu - Cd 3.30 - 13.25
= = = - 0.6633,
Su - Sd 60 - 45
Cd - Sd 13.25 - 45( - 0.6633)

B= = = 41.84, and
1 + rf 1.03
Put value = C = S + B = 50( - 0.6633) + 41.84 = $8.68
Thus, the value of a European put option at time 0 is $8.68.
Making the Model Realistic

Using the methods of the previous section, we can value options given any number of peri-
ods in the binomial stock price tree. But of course, to price an option for an actual stock,
the binomial tree must be a realistic model of the way the stock is likely to evolve in the
future.
While binary up or down movements are not the way stock prices behave on an annual
or even daily basis, they are a much more reasonable description of stock prices over very
short time periods, such as the time between trades. By decreasing the length of each
period, and increasing the number of periods in the stock price tree, we can construct a
realistic model for the stock price. FigureÂ€21.2 shows an example of a stock price path in
which the stock price moves up or down by 1% in each of 900 periods over the year. With
many short periods, these stock price paths look very similar to the price charts for real
stocks. Practitioners routinely use this method to calculate the prices of options and other
types of derivative securities. With a fast computer, prices can be computed very quickly
even with thousands of periods.5
As mentioned earlier, the techniques of the binomial option pricing model are not spe-
cific to European call and put options. We can use it to price any security whose payoff
depends on the stock price. But for the special case of European call and put options, there
is an alternative approach. If we let the length of each period shrink to zero, and the number
of periods per year grows to infinity, the results of the binomial option pricing model can be
calculated using a single, simple formula: the Black-Scholes formula. We consider it next.
Figure 21.2â•‡
80
A Binomial Stock
Price Path 70
The figure depicts a stock

Stock Price ($)
price path with 900 periods 60

during the year, and a ran-
dom stock return of +â•›1%
50
or -â•›1% each period. With
a large number of periods,
and small movements in the 40
stock price each period, the
binomial model is a Â�realistic 30
model of stock price 0 0.25 0.50 0.75 1.0
behavior. Time (Years)
Concept Check 1. What is the key assumption of the binomial option pricing model?
2. Why don’t we need to know the probabilities of the states in the binominal tree in order to solve
for the price of the option?
3. What is a replicating portfolio?
5
There is a question of how to calibrate the up or down movements each period. A standard approach is
to assume the stock’s return each period is {s/ 1n, where s is the stock’s volatility and n is the number
of periods per year.
21.2 The Black-Scholes Option Pricing Model

Although Fischer Black and Myron Scholes did not originally derive it that way, the
Â�Black-Scholes Option Pricing Model can be derived from the Binomial Option Pric-
ing Model by making the length of each period, and the movement of the stock price per
period, shrink to zero and letting the number of periods grow infinitely large. Rather than
derive the formula here, we will state it and focus on its applications.
The Black-Scholes Formula

Before stating the Black-Scholes formula for the price of an option, it is necessary to intro-
duce some terminology. Let S be the current price of the stock, T be the number of years
left to expiration, K be the exercise price, and s be the annual volatility (standard devia-
tion) of the stock’s return. Then, the value, at time t, of a call option on a stock that does
not pay dividends prior to the option’s expiration date is given by
Black-Scholes Price of a Call Option on a Non-Dividend-Paying Stock
C = S * N(d1 ) - PV(K ) * N(d2) (21.7)
where PV(K) is the present value (price) of a risk-free zero-coupon bond that pays K on
the expiration date of the option, N(dâ•›â•›) is the cumulative normal distribution—that is,
the probability, as shown in FigureÂ€21.3, that a normally distributed variable is less than
d—and
ln[S/PV(K )] s 2T
d1 = + and d 2 = d1 - s2T (21.8)
s2T 2
Figure 21.3â•‡
Normal Distribution
N(dâ†œæ¸€), the cumulative normal
Â�distribution, is the probability that
a normally distributed
Â� random
variable will take on a value less
than d. This probability is equal
to the area under the normal
Â�distribution (bell curve) to the N(d )
left of the point d—the shaded
area in the figure. Because it is a
Â�probability, N(dâ†œæ¸€) has a minimum
Â�
value of 0 and a Â�maximum
value of 1. It can be calculated
0 d
in Excel by using the function
NORMSDIST(dâ†œæ¸€).
21.2â•‡ The Black-Scholes Option Pricing Model 799
Interv iew with

Professor Myron S. Scholes is the application of the model. This
co-Â�inventor of the Black-Scholes options Myron S. Scholes Â�illustration became the Black-Â�Scholes
pricing model, for which he won the model. The underlying technology
Nobel Prize for Economic Sciences in does not assume the constancy of either
1997. He is the Frank E. Buck Professor parameter. What impressed and particu-
of Finance, Emeritus, at Stanford larly pleased me was the realization that
Graduate School of Business. investors could price an option without
knowing the expected rate of return on
QUESTION: At the time you derived the the underlying asset or the expected ter-
Black-Scholes formula, did you antici- minal value of the option at its maturity.
pate its influence in the financial world? I believe that the technology to value
options and the underlying economics
ANSWER: Fischer Black and I believed to support its development were the
that the option-pricing Â�technology most important part of our paper.
would be used to value existing
Â�contracts such as options on stock, war- QUESTION: How did you arrive at the
rants, corporate debt, and mortgage insight that you could create a risk-free
contracts. We did not anticipate that portfolio trading the stock and option?
in the future our technology would be
used to develop and price new instru- ANSWER: We first needed to determine
ments, although we were not alone. For how much stock to short against a long
example, several journals rejected our position in the underlying option, such
paper. Only after Merton Miller explained to the editors of the that small movements in the price of
Journal of Political Economy that our findings were not arcane the underlying stock would be offset by opposite movements
but had general importance did it accept our paper. Fischer in the price of the option—a hedged position. As explained
and I rewrote the paper to include a description of the impor- above, if the returns on this combined stock and option
tance of options in the economy, such as how to value the investment were uncorrelated with the market portfolio
stock of a corporation with risky debt in its capital structure. (assuming that CAPM held over short time periods—i.e.,
the returns were normally distributed) or riskless in continu-
QUESTION: What is the most important contribution of the ous time (if investors could trade continuously to adjust their
Black-Scholes formula? stock position), to prevent arbitrage profits the return on the
hedged position had to be equal to the risk-free rate.
ANSWER: The Black-Scholes option paper has two parts:
a technology to value options and an illustration of that
QUESTION: What words of wisdom might you offer future
technology to the pricing of options under a stylized set of
practitioners on using the Black-Scholes formula in light of the
assumptions that was later called the Black-Scholes options
2007–2009 financial crisis?
pricing model. The Nobel Prize was awarded, in part, for
developing the technology to value derivatives. We showed ANSWER: Some blamed models such as ours for the finan-
that if investors could hedge the systematic components of cial crisis. In part, the model can’t be correct other than for
asset returns, then the remaining risks were unsystematic relatively short-dated options; it would not make economic
and the expected return of a portfolio of unsystematic sense to use the same calibration of the pricing technol-
risks will equal the risk-free rate. Moreover, as trading-time ogy over long periods of time. Most of the difficulties in
became continuous, the unsystematic risk would disappear. using models arise from the incorrect use of technology
When we developed the model we did not believe that and assumptions of how to calibrate the models. The crisis
the risk-free rate or the volatility of an asset remained con- highlighted once again that assumptions are important in
stant. We assumed that to be the case, however, to illustrate building and calibrating models.
We need only five input parameters to price the call: the stock price, the strike price, the
exercise date, the risk-free interest rate (to compute the present value of the strike price),
and the volatility of the stock. What is equally notable is what we do not need. Just as we do
not need to know the probabilities in the Binomial Option Pricing Model, we do not need
to know the expected return on the stock to calculate the option price in the Black-Scholes
Option Pricing Model. The expected return of the stock is difficult to measure with great
accuracy as we learned in Part 4; if it were a required input, we could not expect the for-
mula to deliver the option price with much accuracy. Indeed, the only parameter in the
Black-Scholes formula that we need to forecast is the stock’s volatility. Because a stock’s vol-
atility is much easier to measure (and forecast) than its expected return, the Black-Â�Scholes
formula can be very precise.
You might wonder how it is possible to compute the value of a security like an option that
appears to depend critically on the future stock price without knowing the expected return
of the stock. In fact, the expected return of the stock is already reflected in the stock’s cur-
rent price (which is the discounted value of its future payoffs). The Black-Scholes formula
depends on the stock’s current price, and so, in a sense, uses this information implicitly.
The Black-Scholes formula is derived assuming that the call is a European option. Recall
from ChapterÂ€20 that an American call option on a non-dividend-paying stock always has
the same price as its European counterpart. Thus, the Black-Scholes formula can be used to
price American or European call options on non-dividend-paying stocks.
Example 21.3 Valuing a Call Option with the Black-Scholes Formula
Problem
JetBlue Airways does not pay dividends. Using the data in TableÂ€21.1, compare the price on July
24, 2009, for the December 2009 American call option on JetBlue with a strike price of $6 to
the price predicted by the Black-Scholes formula. Assume that the volatility of JetBlue is 65%
per year and that the risk-free rate of interest is 1% per year.
Solution
We use $5.03 (the closing price) for the per-share price of JetBlue stock. Because the
Â�December contract expires on the Saturday following the third Friday of December (Decem-
ber 19), there are 148 days left until expiration. The present value of the strike price is
PV(K ) = 6.00/(1.01)148/365 = $5.976. Calculating d1 and d 2 from Eq. 21.8 gives
ln[S/PV(K )] s 2T
d1 = +
s2T 2
ln(5.03/5.976) 0.652148
365
= + = - 0.209
0.652148 2
365
d2 = d1 - s2T = - 0.209 - 0.652148

365 = - 0.623
Substituting d1 and d2 into the Black-Scholes formula given by Eq. 21.7 results in
C = S * N(d 1) - PV(K ) * N(d2)
= 5.03 * 0.417 - 5.976 * 0.267
= $0.50
In TableÂ€21.1, the bid and ask prices for this option are $0.45 and $0.55.
Table 21.1 JetBlue Option Quotes
JBLU 5.03 0.11

Jul 24 2009 @ 17:17 ET Bid 5.03 Ask 5.04 Size 168 96 Vol 7335887
Open Open
Calls Bid Ask Vol Puts Bid Ask Vol
Int Int
09 Dec 5.00 (JGQ LA) 0.80 0.90 47 5865 09 Dec 5.00 (JGQ XA) 0.80 0.90 6 1000
09 Dec 6.00 (JGQ LF) 0.45 0.55 2 259 09 Dec 6.00 (JGQ XF) 1.40 1.50 0 84
10 Jan 5.00 (JGQ AA) 0.85 1.00 125 6433 10 Jan 5.00 (JGQ MA) 0.85 0.95 10 14737
10 Jan 6.00 (JGQ AF) 0.50 0.60 28 0 10 Jan 6.00 (JGQ MF) 1.45 1.55 0 22
10 Jan 9.00 (JGQ AI) 0.05 0.15 0 818 10 Jan 9.00 (JGQ MI) 4.00 4.10 0 0
10 Mar 5.00 (JGQ CA) 1.05 1.15 0 50 10 Mar 5.00 (JGQ OA) 1.00 1.10 0 40
10 Mar 6.00 (JGQ CF) 0.65 0.75 0 146 10 Mar 6.00 (JGQ OF) 1.60 1.70 10 41
10 Mar 7.00 (JGQ CG) 0.40 0.50 5 3 10 Mar 7.00 (JGQ OG) 2.30 2.45 10 0
FigureÂ€21.4 plots the value of the call option in Example 21.3 as a function of JetBlue’s
current stock price. Notice how the value of the option always lies above its intrinsic value.
European Put Options.â•‡ We can use the Black-Scholes formula to compute the price
of a European put option on a non-dividend-paying stock by using the put-call parity
formula we derived in ChapterÂ€ 20 (see Eq. 20.3). The price of a European put from
put-call parity is
P = C - S + PV(K )
Substituting for C using the Black-Scholes formula gives

Black-Scholes Price of a European Put Option on a Non-Dividend-Paying Stock
P = PV(K )[1 - N(d 2 )] - S[1 - N(d 1)] (21.9)
Figure 21.4â•‡
4.0
Black-Scholes Value
on July 24, 2009, of
3.0
the December 2009 $6
Call Value ($)
Call on JetBlue Stock

The red curve shows the 2.0
Black-Scholes value of the Intrinsic Value
call option as a function
Â�
of JetBlue’s
Â� stock price. 1.0
The circle shows the value
at JetBlue’s
Â� current price Strike Price
of $5.03. The black line 0.0
is the intrinsic value of the 2 3 4 5 6 7 8 9 10
call.
Stock Price ($)
Example 21.4 Valuing a Put Option with the Black-Scholes Formula
Problem
Using the Black-Scholes formula and the data in TableÂ€ 21.1, compute the price of a January
2010 $5 put option and compare it to the price in the market. Is the Black-Scholes formula the
correct way to price these options? (As before, assume that the volatility of JetBlue is 65% per
year and that the risk-free rate of interest is 1% per year.)
Solution
The contract expires on January 16, 2010, or 176 days from the quote date. The present value of the
strike price is PV(K ) = 5.00/(1.01)176/365 = $4.976. Calculating d1 and d 2 from Eq. 21.8 gives
ln[S/PV (K )] s2T
d1 = +
s2T 2
ln(5.03/4.976) 0.652176
365
= + = 0.250
0.652176 2
365
176
d2 = d1 - s2T = 0.250 - 0.652365 = - 0.201
Substituting d1 and d 2 into the Black-Scholes formula for a put option, using Eq. 21.9, gives
P = PV (K )[1 - N(d2)] - S [1 - N(d1)]
= 4.976 * (1 - 0.420) - 5.03 * (1 - 0.599)
= $0.87
Given the bid and ask prices of $0.85 and $0.95, respectively, for the option, this estimate is
within the bid-ask spread. But the Black-Scholes formula for puts is valid for European options,
and the quotes are for American options. Hence, in this case, the Black-Scholes option price is
a lower bound on the actual value of the put, as an American put might be exercised early to
benefit from interest on the strike price. However, given that interest on the $5 strike price is less
than $0.03, in this case the approximation is a close one.
FigureÂ€21.5 plots the Black-Scholes value of the European put option in Example 21.4
as a function of JetBlue’s stock price. Recall from ChapterÂ€20 that the time value of deep-
in-the-money European puts can be negative. While the put value does falls below its
intrinsic value in FigureÂ€21.5, the effect is slight in this case given low current interest rates
and the relatively short time to expiration of the option.
Dividend-Paying Stocks.â•‡ The Black-Scholes formula applies to call options on non-
dividend-paying stocks. However, we can easily adjust the formula for European options
on dividend-paying stocks.
The holder of a European call option does not receive the benefit of any dividends that
will be paid prior to the expiration date of the option. Indeed, as we saw in ChapterÂ€17, the
stock price tends to drop by the amount of the dividend when the stock goes ex-dividend.
Because the final stock price will be lower, dividends decrease the value of a call option.
Let PV(Div) be the present value of any dividends paid prior to the expiration date of
the option. Then, a security that is identical to the stock, but that did not pay any of these
dividends, would have a current market price of
S x = S - PV(Div) (21.10)
Figure 21.5â•‡
5.0
Black-Scholes Value
on July 24, 2009, of
4.0
the January 2010 $5
Put on JetBlue Stock
The red curve shows the 3.0
Put Value ($)

Black-Scholes value of the
put option as a function
Â� of
Â�JetBlue’s stock price. The
2.0
circle shows the value at
Â�JetBlue’s current price of
$5.03. The black line is Intrinsic Value
1.0
the intrinsic value of the
put. For stock prices below
Strike Price
$2.25, the European put’s
0.0
value is slightly less than its 0 1 2 3 4 5 6 7 8 9 10
intrinsic value.
Stock Price ($)
The value S x is the current price of the stock excluding any dividends prior to Â�expiration.
Because a European call option is the right to buy the stock without these dividends, we can
evaluate it using the Black-Scholes formula with S x in place of S.
A useful special case is when the stock will pay a dividend that is proportional to its
stock price at the time the dividend is paid. If q is the stock’s (compounded) dividend yield
until the expiration date, then6
S x = S/(1 + q) (21.11)
Valuing a Dividend-Paying European Call Option with the

Example 21.5
Black-Scholes Formula
Problem
World Wide Plants will pay an annual dividend yield of 5% on its stock. Plot the value of
a Â�one-year European call option with a strike price of $20 on World Wide Plants stock as a
Â�function of the stock price. Assume that the volatility of World Wide Plants stock is 20% per
year and that the one-year risk-free rate of interest is 4%.
Solution
The price of the call is given by the standard Black-Scholes formula, Eq. 21.7, but with the
stock price replaced throughout with S x = S/(1.05). For example, with a stock price of $30,
S x = 30/(1.05) = 28.57, PV(K ) = 20/1.04 = 19.23, and
6
To see why, suppose that whenever the dividend is paid, we reinvest it. Then, if we buy 1/(1 + q) shares
today, at expiration we will own [1/(1 + q)] * (1 + q) = 1 share. Thus, by the Law of One Price, the value
today of receiving 1 share at expiration is S/(1 + q).
ln[S x/PV(K )] s 2T
d1 = +
s2T 2
ln(28.57/19.23)
= + 0.1 = 2.08
0.2
d2 = d1 - s2T = 2.08 - 0.2 = 1.88

so
C(S ) = S xN(d1) - PV(K )N(d2) = 28.57(0.981) - 19.23(0.970) = 9.37
The plot below shows the value of the call (in red) for different levels of the stock price. When
the stock price is sufficiently high, the call is worth less than its intrinsic value.
10
Intrinsic
Value
8
Call Value ($)
2
Strike Price
0
10 15 20 25 30
Stock Price ($)
Implied Volatility
Of the five required inputs in the Black-Scholes formula, four are directly observable:
S,Â€K, T, and the risk-free interest rate. Only one parameter, s, the volatility of the stock
price, is not directly observable. Practitioners use two strategies to estimate the value of this
variable. The first, most straightforward approach is to use historical data on daily stock
returns to estimate the volatility of the stock over the past several months. Because volatil-
ity tends to be persistent, such estimates can provide a reasonable forecast for the stock’s
volatility in the near future.
The second approach is to use the current market prices of traded options to “back
out” the volatility that is consistent with these prices based on the Black-Scholes
Â�formula. An estimate of a stock’s volatility that is implied by an option’s price is known
as an implied volatility. The implied volatility from one option can be used to estimate
the value of other options on the stock with the same expiration date (as well as those
with different expiration dates if the stock’s volatility is not expected to change over
time).
Example 21.6 Computing the Implied Volatility from an Option Price
Problem
Use the price of the March 2010 call on JetBlue with a strike price of $5 in TableÂ€ 21.1 to
Â�calculate the implied volatility for JetBlue from July 2009 to March 2010. Assume the risk-free
rate of interest is 1% per year.
Solution
The call expires on March 20, 2010, or 239 days after the quote date. The stock price is $5.03,
and PV (K ) = 5.00/(1.01)239/365 = $4.968. Substituting these values into the Black-Scholes
Â�formula, Eq. 21.7, gives
C = 5.03N(d1) - 4.968N(d2)
where
ln(5.03/4.968) s 2239
365
d1 = + and d2 = d1 - s 2239
365
s2239 2
365
We can compute the Black-Scholes option value C for different volatilities using this equation.
The option value C increases with s, and equals $1.10 (average bid and ask price for the call)
when s 67%. (You can find this value by trial and error or by using Excel’s Solver tool.) If
we look at the bid price of $1.05, the implied volatility is about 64%, and at the ask price of
$1.15, the implied volatility is about 70%. Thus, the 65% volatility we used in Example 21.3
and Example 21.4 is within the bid-ask spread for the option.
Global Financial Crisis The VIX Index

The use of the Black-Scholes option pricing formula to crisis and heightened uncertainty. This effect is illustrated most
Â�
compute implied volatility has become so ubiquitous that in dramatically during the U.S. financial crisis, with the VIX
January 1990 the Chicago Board Options Exchange introduced nearly quadrupling between September and October 2008,
the VIX Index, which tracks the one-month implied volatility to a level almost twice its previous all-time high. The index
of options written on the S&P 500 index. Quoted in percent remained at these historically high levels for several months,
per annum, this index has since become one of the most-cited reflecting the unprecedented uncertainty that accompanied
measures of market volatility. Because it characterizes the level the financial crisis. As this uncertainty dissipated in mid-2009,
of investor uncertainty, it is often referred to as the “fear index.” the index began to drop, reflecting renewed investor confi-
As the figure below shows, while the average level of the dence. Since then, however, uncertainty in Europe and Asia
VIX is about 20%, the index does indeed rise during times of has led to time periods when the VIX again topped 40%.
U.S. Financial
Crisis
80 End of
Russian Dot-Com
Financial Collapse
60 Crisis 9-11
Asian Terrorist Lehman Euro Crisis China's “Black
Persian
VIX (%)
Financial Attack Iraq Defaults

Gulf Monday”
40 War Crisis War Subprime
Collapse
20
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Year
Source: Yahoo! Finance
The Replicating Portfolio

Although we introduced the concept of the replicating portfolio in the discussion of the
Binomial Option Pricing Model, it was actually Fischer Black and Myron Scholes who
discovered this important insight while deriving their model. To see how the replicating
portfolio is constructed in the Black-Scholes Model, recall from the Binomial Option Pric-
ing Model that the price of a call option is given by the price of the replicating portfolio,
as shown in Eq. 21.6:
C = S + B
Comparing this expression to the Black-Scholes formula from Eq. 21.7 gives the shares of
stock and amount in bonds in the Black-Scholes replicating portfolio:
Black-Scholes Replicating Portfolio of a Call Option
= N(d1)
B = - PV(K )N(d 2 ) (21.12)
Recall that N(dâ†œæ¸€) is the cumulative normal distribution function; that is, it has a minimum
value of 0 and a maximum value of 1. So, is between 0 and 1, and B is between - K
and 0. The option delta, , has a natural interpretation: It is the change in the price of
the option given a $1 change in the price of the stock. Because is always less than 1, the
change in the call price is always less than the change in the stock price.
Example 21.7 Computing the Replicating Portfolio
Problem
PNA Systems pays no dividends and has a current stock price of $10 per share. If its returns have
a volatility of 40% and the risk-free rate is 5%, what portfolio would you hold today to replicate
a one-year at-the-money call option on the stock?
Solution
We can apply the Black-Scholes formula with S = 10, PV(K ) = 10/1.05 = 9.524, and
ln[S/PV(K )] s2T ln(10/9.524) 40%

d1 = + = + = 0.322
s2T 2 40% 2
d2 = d1 - s2T = 0.322 - 0.40 = - 0.078

From Eq. 21.12, the replicating portfolio for the option is
= N(d1) = N(0.322) = 0.626
B = - PV(K )N(d2) = - 9.524 * N ( - 0.078) = - 4.47
That is, we should buy 0.626 shares of the PNA stock, and borrow $4.47, for a total cost of
$10(0.626) - 4.47 = $1.79, which is the Black-Scholes value of the call option.
FigureÂ€21.6 illustrates the replicating portfolio (yellow line) and call option value (red
curve), as a function of the stock price, for Example 21.7. Because the red curve and
yellow line are tangent (with slope ) at the initial stock price, the value of the replicat-
ing portfolio will approximate the value of the call option for small changes to the stock
price. But as the stock price changes, the replicating portfolio will need to be updated to
Figure 21.6â•‡
10
Replicating Portfolio Black-Scholes
for the Call Option Option Value
in Example 21.7
The replicating portfolio has
the same initial value as the
call option, and the same 5 Current Stock
initial sensitivity to the stock Price
price (given by ). Because
Value ($)
the red curve and the yellow
line are tangent, the value of 1.79
Intrinsic Value
the replicating portfolio will
approximate the value of the 0
call option for small changes 2 4 6 8 10 12 14 16 18 20
to the stock price. But to
maintain accuracy, the rep-
licating portfolio must be Replicating Portfolio
updated as the stock price ( 0.626, B 4.47)
changes.
5
Stock Price ($)
maintain accuracy. For example, if the stock price increases, the replicating portfolio will
correspond to a new, steeper tangent line higher on the red curve. Because a steeper line
corresponds to a higher , to replicate the option it is necessary to buy shares as the stock
price increases.
This dynamic trading strategy is analogous to the ones we derived earlier for the Bino-
mial Option Pricing Model. In the binomial model, we were able to replicate the payoff of
an option because we only needed to match two of its payoffs at any time. The great insight
of Black, Scholes, and Merton was that if we can update our portfolio continuously, we can
replicate an option on the stock by constantly adjusting our portfolio to remain on a line
that is tangent to the value of the option.
Notice that the replicating portfolio of a call option always consists of a long position
in the stock and a short position in the bond; in other words, the replicating portfolio is
a leveraged position in the stock. Because a leveraged position in a stock is riskier than
the stock itself, this implies that call options on a positive beta stock are more risky than the
underlying stock and therefore have higher returns and higher betas.
We can also derive the replicating portfolio for a put option. Comparing the
Â�Black-Scholes price of a put from Eq. 21.9 with Eq. 21.6 gives
Black-Scholes Replicating Portfolio of a Put Option
= - [1 - N(d1)]
B = PV(K )[1 - N(d2)] (21.13)
In this case, is between - 1 and 0, and B is between 0 and K. Thus, the replicating port-
folio of a put option always consists of a long position in the bond and a short position in
the stock, implying that put options on a positive beta stock will have a negative beta.
Concept Check 1. What are the inputs of the Black-Scholes option pricing formula?
2. What is the implied volatility of a stock?
3. How does the delta of a call option change as the stock price increases?
21.3 Risk-Neutral Probabilities

In both the Binomial and Black-Scholes Pricing Models, we do not need to know the
probability of each possible future stock price to calculate the option price. But what if we
did know these probabilities? In that case, we could calculate the price of the option as we
have done for other financial assets: We could calculate the expected payoff of the option
and discount it at the appropriate cost of capital. The drawback of this approach is that
even if we know the probabilities, it is very difficult to estimate the cost of capital for a
particular asset, and options are no exception. There is, however, one case in which the cost
of capital can be precisely estimated. If all market participants were risk neutral, then all
financial assets (including options) would have the same cost of capital—the risk-free rate
of interest. Let’s consider that scenario and see its implications for option prices.
A Risk-Neutral Two-State Model

Imagine a world consisting of only risk-neutral investors, and consider the two-state exam-
ple in SectionÂ€21.1 in the risk-neutral world. Recall that the stock price today is equal to
$50. In one period it will either go up by $10 or go down by $10, and the one-period risk-
free rate of interest is 6%. Let r be the probability that the stock price will increase, which
means (1 - r) is the probability that it will go down. The value of the stock today must
equal the present value of the expected price next period discounted at the risk-free rate:
60r + 40(1 - r)
50 = (21.14)
1.06
This equation is solved with r = 65%. Because we now know the probability of each state,
we can price the call by calculating the present value of its expected payoff next period.
Recall that the call option had an exercise price of $50, so it will be worth either $10 or
nothing at expiration. The present value of the expected payouts is
10(0.65) + 0(1 - 0.65)

= 6.13 (21.15)
1.06
This is precisely the value we calculated in SectionÂ€21.1 using the Binomial Option Pricing
Model where we did not assume that investors were risk neutral. It is not a coincidence.
Because no assumption on the risk preferences of investors is necessary to calculate the
option price using either the Binomial Model or the Black-Scholes formula, the models
must work for any set of preferences, including risk-neutral investors.
Implications of the Risk-Neutral World

Let’s take a step back and consider the importance of the conclusion that if we use the
Binomial Model or Black-Scholes Model to price options, we do not need to make any
assumption regarding investor risk preferences, the probability of each state, or the stock’s
expected return. These models give the same option price no matter what the actual risk
21.3â•‡ Risk-Neutral Probabilities 809
preferences and expected stock returns are. To understand how these two settings can be
Â�consistent with the same prices for securities, consider the following:
n In the real world, investors are risk averse. Thus, the expected return of a typical stock
includes a positive risk premium to compensate investors for risk.
n In the hypothetical risk-neutral world, investors do not require compensation for risk.
So for the stock price to be the same as in real world, investors must be more pessimistic.
Thus, stocks that in reality have expected returns above the risk-free rate, when evalu-
ated using these more pessimistic probabilities, have expected returns that equal the
risk-free rate.
In other words, the r in Eq. 21.14 and Eq. 21.15 is not the actual probability of the stock
price increasing. Rather, it represents how the actual probability would have to be adjusted
to keep the stock price the same in a risk-neutral world. For this reason, we refer to r and
(1 - r) as risk-neutral probabilities. These risk-neutral probabilities are known by other
names as well: state-contingent prices, state prices, or martingale prices.
To illustrate, suppose the stock considered above, with a current price of $50, will increase
to $60 with a true probability of 75%, or fall to $40 with a true probability of 25%:
0 1
60
%
75
50
25
%
40
This stock’s true expected return is therefore
60 * 0.75 + 40 * 0.25
- 1 = 10%
50
Given the risk-free interest rate of 6%, this stock has a 4% risk premium. But as we cal-
culated earlier in Eq. 21.14, the risk-neutral probability that the stock will increase is
r = 65%, which is less than the true probability. Thus, the expected return of the stock
in the risk-neutral world is (60 * 0.65 + 40 * 0.35)/50 - 1 = 6% (equal to the risk-free
rate). To ensure that all assets in the risk-neutral world have an expected return equal to
the risk-free rate, relative to the true probabilities, the risk-neutral probabilities overweight
the bad states and underweight the good states.
Risk-Neutral Probabilities and Option Pricing

We can exploit the insight that if the stock price dynamics are the same in the risk-neutral
and risk-averse worlds, the option prices must be the same, to develop another technique
for pricing options. Consider again the general binomial stock price tree:
0 1
Stock Option
Su Cu
Sd Cd
First, we can compute the risk-neutral probability that makes the stock’s expected return
equal to the risk-free interest rate:
rSu + (1 - r)Sd
- 1 = rf
S
Solving this equation for the risk-neutral probability r we get
(1 + rf )S - Sd
r= (21.16)
S u - Sd
We can then compute the value of the option by computing its expected payoff using the
risk-neutral probabilities, and discount the expected payoff at the risk-free interest rate.
Example 21.8 Option Pricing with Risk-Neutral Probabilities
Problem
Using Narver Network Systems stock from Example 21.2, imagine all investors are risk neutral
and calculate the probability of every state in the next two years. Use these probabilities to calcu-
late the price of a two-year call option on Narver Network Systems stock with a strike price $60.
Then, price a two-year European put option with the same strike price.
Solution
The binomial tree in the three-state example is
0 1 2
72
60
Stock 50 54
45
40.5
First, we use Eq. 21.16 to compute the risk-neutral probability that the stock price will increase.
At time 0, we have
(1 + rf )S - Sd (1.03)50 - 45
r= = = 0.433
S u - Sd 60 - 45
Because the stock has the same returns (up 20% or down 10%) at each date, we can check that
the risk-neutral probability is the same at each date as well.
Consider the call option with a strike price of $60. This call pays $12 if the stock goes
up twice, and zero otherwise. The risk-neutral probability that the stock will go up twice is
0.433 * 0.433, so the call option has an expected payoff of
0.433 * 0.433 * $12 = $2.25
We compute the current price of the call option by discounting this expected payoff at the
Â�risk-free rate: C = $2.25/1.032 = $2.12.
21.4â•‡ Risk and Return of an Option 811
Next, consider the European put option with a strike price of $60. The put ends up in the
money if the stock goes down twice, if it goes up and then down, or if it goes down and then
up. Because the risk-neutral probability of a drop in the stock price is 1 - 0.433 = 0.567, the
expected payoff of the put option is
0.567 * 0.567 * $19.5 + 0.433 * 0.567 * $6 + 0.567 * 0.433 * $6 = $9.21
The value of the put today is therefore P = $9.21/1.032 = $8.68, which is the price we Â�calculated
in Example 21.2.
As the calculation of the put price in Example 21.8 makes clear, by using the probabili-
ties in the risk-neutral world we can price any derivative security—that is, any security
whose payoff depends solely on the prices of other marketed assets. After we have con-
structed the tree and calculated the probabilities in the risk-neutral world, we can use them
to price the derivative by simply discounting its expected payoff (using the risk-neutral
probabilities) at the risk-free rate.
The risk-neutral pricing method is the basis for a common technique for pricing deriva-
tive securities called Monte Carlo simulation. In this approach, the expected payoff of
the derivative security is estimated by calculating its average payoff after simulating many
random paths for the underlying stock price. In the randomization, the risk-neutral prob-
abilities are used, and so the average payoff can be discounted at the risk-free rate to esti-
mate the derivative security’s value.
Concept Check 1. What are risk-neutral probabilities? How can they be used to value options?
2. Does the binominal model or Black-Scholes model assume that investors are risk neutral?
21.4 Risk and Return of an Option

To measure the risk of an option, we must compute the option beta. The simplest way to
do so is to compute the beta of the replicating portfolio. Recall that the beta of a portfolio
is just the weighted average beta of the constituent securities that make up the portfolio. In
this case, the portfolio consists of S * dollars invested in the stock and B dollars invested
in the bond, so the beta of an option is
S B
boption = bS + b
S + B S + B B
where b S is the stock’s beta and bB is the bond’s beta. In this case the bond is riskless, so
bB = 0. Thus, the option beta is
Option Beta
S
b option = b (21.17)
S + B S
Recall that for a call option, is greater than zero and B is less than zero. Thus, for a call
written on a stock with positive beta, the beta of the call always exceeds the beta of the
stock. For a put option, is less than zero and B is greater than zero; thus the beta of a
put option written on a positive beta stock is always negative. This result should not be
Â�surprising. A put option is a hedge, so its price goes up when the stock price goes down.
Example 21.9 Option Beta
Problem
Calculate the betas of the JetBlue call and put options in Examples 21.3 and 21.4, assuming
JetBlue’s stock has a beta of 0.85.
Solution
From Example 21.3, the December 2009 $6 call option has a value of C = $0.50 and a delta of
N(d1) = 0.417. Thus, its beta is given by
S S * N(d1)
b Call = b Stock = b Stock
S + B C
5.03 * 0.417
= * 0.85 = 3.57
0.50
Similarly, the beta of the January 2010 $5 put option is given by
S - S[1 - N(d1)]
b Put = b Stock = b Stock
S + B P
- 5.03[1 - 0.599]
= * 0.85 = - 1.97
0.87
The expression S/(S + B) is the ratio of the amount of money in the stock position
in the replicating portfolio to the value of the replicating portfolio (or the option price); it
is known as the option’s leverage ratio. FigureÂ€21.7 shows how the leverage ratio changes
for puts and calls. As the figure shows, the magnitude of the leverage ratio for options can
Figure 21.7â•‡
30
Leverage Ratios of 25
Out-of-the-Money
Options Call Options
The leverage ratio for a call 20
option is always greater than
15
1, but Â�out-of-the-money
Leverage Ratio
calls have higher leverage 10

ratios than in-the-money In-the-Money
calls. Put leverage ratios are 5 Call Options
always negative, and out-of-
the-money puts have more 0
negative leverage ratios In-the-Money
than in-the-money puts. 5 Put Options
Strike Price
Data shown is for one-year
10 Out-of-the-Money
options on a stock with a
Put Options
Â�
30% volatility, given a risk-
15
free interest rate of 5%. 0 25 50 75 100 125 150 175 200
Stock Price ($)
21.5â•‡ Corporate Applications of Option Pricing 813
Figure 21.8â•‡
Security Market Line

Out-of-the-Money Call
and Options
Expected Return
The figure shows how the In-the-Money Call
expected return of different
Â� Riskless Bond
Stock
options are related. In-the-Money Put
Protected Stock
(buy stock and put)
0 Beta
Out-of-the-Money Put
be very large, especially for inexpensive out-of-the-money options. Thus, calls and puts on
a positive beta stock have very large positive and negative betas, respectively. Note also that
as the stock price changes, the beta of an option will change, with its magnitude falling as
the option goes in-the-money.
Recall that expected returns and beta are linearly related. Hence, out-of-the-money calls
have the highest expected returns and out-of-the-money puts have the lowest expected
returns. The expected returns of different options are plotted on the security market line
in FigureÂ€21.8.
Concept Check 1. Is the beta of a call greater or smaller than the beta of the underlying stock?
2. What is the leverage ratio of a call?
21.5 Corporate Applications of Option Pricing

We close this chapter by developing two corporate applications of option pricing: (1)
unlevering the beta of equity and calculating the beta of risky debt and (2) deriving the
Â�approximation formula to value debt overhang that we introduced in ChapterÂ€16.
Beta of Risky Debt

In ChapterÂ€14, we explained how to calculate the beta of equity from the unlevered beta of
equity. If we make the common approximation that the beta of debt is zero, then
D D
bE = bU + (b U - b D) ¢1 + ≤b U (21.18)
E E
where bE is the beta of equity and b U is the beta of unlevered equity (or the beta of the
firm’s assets). However, for companies with high debt-to-equity ratios, the approximation
that the beta of debt is zero is unrealistic; such corporations have a positive probability of
bankruptcy, and this uncertainty usually has systematic components.
To derive an expression for the beta of equity when the beta of debt is not zero, recall
from the discussion in ChapterÂ€ 20 that equity can be viewed as a call option on the
firm’s assets.7 If we let A be the value of the firm’s assets, E be the value of equity, and D
be the value of debt, then because equity is a call option on the assets of the firm, we can
write the value of equity in terms of a replicating portfolio of the firm’s assets and a risk-
free bond,
E = A + B
where the value of the firm’s assets A = E + D is used in place of the stock price S to rep-
resent the underlying asset on which the option is written. Substituting these expressions
into Eq. 21.17 gives an expression for the beta of equity that does not assume the beta of
the firm’s debt is zero:
A (E + D) D
bE = bU = bU = ¢1 + ≤bU (21.19)
A + B E E
Note that when the debt is risk free, the firm’s equity is always in-the-money; thus = 1
and Eq. 21.19 reduces to Eq. 21.18.
We can derive the beta of debt in a similar fashion. Debt, D, is equal to a portfolio
consisting of a long position in the assets of the firm and a short position in its equity; i.e.,
D = A - E. The beta of debt is therefore the weighted-average beta of this portfolio:
A E
bD = bU - bE
D D
Using Eq. 21.19 and simplifying gives an expression for the beta of debt in terms of the
beta of assets:
A E
bD = (1 - ) bU = (1 - )¢1 + ≤bU (21.20)
D D
Again, when the debt is riskless, = 1 and b D = 0, the assumption we made in

Eq.Â€21.18.
FigureÂ€21.9 plots an example of the beta of debt and equity as a function of the firm’s
leverage using Eq. 21.12. For low levels of debt, the approximation that the beta of debt is
zero works reasonably well. As the debt-to-equity ratio becomes larger, however, the beta
of debt begins to rise above zero and the beta of equity no longer increases proportionally
with the debt-equity ratio.
In most applications, the beta of equity can be estimated. Using the beta of equity, we
can calculate the beta of debt and the unlevered beta. For example, to unlever the beta, we
can solve Eq. 21.19 for b U :
bE
bU = (21.21)
D
¢1 + ≤
E
7
The idea to view debt and equity as options was first developed by R. Merton in “On the Pricing of Cor-
porate Debt: The Risk Structure of Interest Rates,” Journal of Finance 29 (1974): 449–470.
Figure 21.9â•‡
3.0
Equity Beta when bD 0
Beta of Debt and Equity 2.5 bE
The blue curve is the beta of
equity and the red curve is 2.0
the beta of debt as a func-
Beta
tion of the firm’s debt-to-
1.5
equity ratio. The black line
shows the beta of equity
1.0
when the beta of debt is
assumed to be zero. The bD
firm is assumed to hold five- 0.5
year zero-coupon debt and
reinvest all its earnings. The 0.0
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5
firm’s beta of assets is one,
Market Debt-Equity Ratio
the Â�risk-free interest rate is
3% per year, and the volatil-
ity of assets is 30% per year.
Example 21.10 Computing the Beta of Debt
Problem
You would like to know the beta of debt for BB Industries. The value of BB’s outstanding equity
is $40 million, and you have estimated its beta to be 1.2. However, you cannot find enough
market data to estimate the beta of its debt, so you decide to use the Black-Scholes formula to
find an approximate value for the debt beta. BB has four-year zero-coupon debt outstanding
with a face value of $100 million that currently trades for $75 million. BB pays no dividends
and reinvests all of its earnings. The four-year risk-free rate of interest is currently 5.13%. What
is the beta of BB’s debt?
Solution
We can interpret BB’s equity as a four-year call option on the firm’s assets with a strike price of
$100 million. The present value of the strike price is $100 million/(1.0513)4 = $81.86 million.
The current market value of BB’s assets is $40 + 75 = $115 million. Therefore, the implied
volatility of BB’s assets is equal to the implied volatility of a call option whose price is 40 when
the stock price is 115 and the present value of the strike price is 81.86. Using trial and error, we
find an implied volatility of about 25%. With this volatility, the delta of the call option is
ln(115/81.86)
= N (d1) = N ¢ + 0.25 ≤ = 0.824
0.25(2)
First, we use Eq. 21.21 to solve for BB’s unlevered beta:
bE 1.2
bU = = = 0.51
D 75
¢1 + ≤ 0.824¢1 + ≤
E 40
We can then use Eq. 21.20 to estimate the beta of BB’s debt:
E 40
b D = (1 - )¢1 + ≤b = (1 - 0.824)¢1 + ≤0.51 = 0.14
D U 75
Common Mistake Valuing Employee Stock Options

In the last 20 years, it has become common practice to Unless the number of options is large relative to the
compensate executives by granting them executive stock total number of shares outstanding, the first difference is
options (ESOs)—call options on their company’s stock. not that important. The second difference is important
Until 2005, U.S. accounting standards did not require for employees and firms with high employee turnover.
firms to include stock option grants as part of their com- The third difference is very important for employees
pensation expense. Now, however, firms are required to and all firms. Employees are risk-averse, but are not per-
expense these options when calculating their earnings. mitted to hedge the risk of the option by trading the rep-
Regardless of the accounting requirement, both firms and licating portfolio. As a consequence, the employee’s
employees would like to know the value of this compensa- preferences and beliefs matter in computing the ESO’s
tion. While it is tempting to use the Black-Scholes formula value: A more risk-averse or pessimistic employee will
to value an ESO, there are several important pitfalls to be attach a lower value to the option than a less risk-averse
aware of when doing so. or optimistic employee. Furthermore, the only way an
To understand the difficulties of using the Black- employee can eliminate his or her risk from the option is
Scholes formula to value ESOs, it is important to appre- to exercise it and sell the stock. Hence, most employees
ciate how they are usually granted. ESOs are typically choose to exercise early.* In this case, employees are forfeit-
American-style options with exercise dates up to 10 ing the (often substantial) remaining time value of their
years in the future. However, there is usually a vesting options in exchange for a reduction in their risk.
period (often as long as four years) during which the Thus, the Black-Scholes formula (which assumes
employee does not actually own the option. Instead, he no early exercise) overestimates the cost of the option
or she owns a right to the option at the end of the vest- to the firm and its benefit to the employee. Because the
ing period. If the employee leaves the firm during this firm can hedge its option liabilities, risk is not an issue
period, the individual forfeits this right and so does not when evaluating the cost of the option to the firm. Thus,
get the option. Once the vesting period has passed, the the Black-Scholes formula overstates the cost by not
employee owns the option but it is not tradable—the accounting for forfeitures and early exercise. Because the
only way the employee can liquidate the option is by employee cannot sell or hedge the risk of the option, the
exercising it. Furthermore, most executives face restric- Black-Scholes formula overstates the value of the option
tions in trading their own company stock, so they effec- to the employee even further by not accounting for the
tively cannot construct a replicating portfolio. Because of personal cost of bearing risk.
these restrictions, ESOs are not worth the same amount How important are these differences? The answer
to the employee and the firm. appears to be very important. In a recent paper, Ashish
One obvious difficulty with applying the Black-Â�Scholes Jain and Ajay Subramanian adjust for these differences
formula to such options is that the formula requires an and find that for reasonable parameter values, the Black-
estimate of the volatility of the stock over the life of Scholes formula can overestimate the cost to the firm of a
the option. Forecasting volatility up to 10 years in the vested five-year option by as much as 40%.† And once
future is extremely difficult. But even if the stock’s vola- one considers the personal cost of being under-Â�diversified
tility were known, the Black-Scholes formula does not while holding the option, its value to the employee can
account for the following important differences between be as low as one third of the cost of the option to the
ESOs and ordinary stock options: firm. To account for these discrepancies, researchers have
developed methods based on the binomial model in Sec-
1. ESOs are dilutive.â•… When exercised, they increase
tionÂ€21.1, that incorporate the probability and effect of
the number of shares outstanding of the firm.
forfeiture and early exercise directly into the binomial
2. ESOs may be forfeited.â•… If the employee leaves the tree (see Further Readings).
firm, options that are not vested are immediately
forfeited. Options already vested are forfeited if not
exercised within three months of the employee’s *See S. Huddart and M. Lang, “Employee Stock Option Exercises: An
departure. Empirical Analysis,” Journal of Accounting and Â�Economics 21 (1996): 5–43.
3. ESOs may be exercised early.â•… Once vested, the †
“The Intertemporal Exercise and Valuation of Employee Options,”
employee can exercise the options at any time. Accounting Review 79 (2004): 705–743.
NOBEL PRIZE The 1997 Nobel Prize in Economics
In a modern market economy, it is essential that firms and This year’s laureates, Robert Merton and Myron Scholes,
households are able to select an appropriate level of risk in developed this method in close collaboration with Fischer
their transactions. Markets for options and other so-called Black, who died in his mid-fifties in 1995. Black, Merton, and
derivatives are important in the sense that agents who antici- Scholes thus laid the foundation for the rapid growth of
pate future revenues or payments can ensure a profit above a markets for derivatives in the last ten years. Their method has
certain level or insure themselves against a loss above a certain more general applicability, however, and has created new areas
level. A prerequisite for efficient management of risk, however, of research—inside as well as outside of financial economics. A
is that such instruments are correctly valued, or priced. A new similar method may be used to value insurance contracts and
method to determine the value of derivatives stands out among guarantees, or the flexibility of physical investment projects.
the foremost contributions to economic sciences over the last Source: “The Prize in Economic Sciences 1997—Press Release.”
25 years. Nobelprize.org.
Agency Costs of Debt

In ChapterÂ€16 we noted that leverage can distort equity holders’ incentives to invest. These
distortions can be readily understood when we view equity as a call option on the firm’s
assets. First, leverage creates an asset substitution problem because the value of the equity
call option increases with the firm’s volatility. Thus, equity holders may have an incentive
to take excessive risk. Second, because 6 1 for a call option, equity holders gain less than
$1 for each $1 increase in the value of the firm’s assets, reducing their incentive to invest
and leading to a debt overhang or underinvestment problem. Example 21.11 illustrates
how we can use the methods of this chapter to quantify both of these effects.
Example 21.11 Evaluating Potential Agency Costs
Problem
Consider BB Industries from Example 21.10. Suppose BB can embark on a risky strategy that
would increase the volatility of BB’s assets from 25% to 35%. Show that shareholders benefit
from this risky strategy even if it has an NPV of - $5 million. Alternatively, suppose BB tries to
raise $100,000 from shareholders to invest in a new positive NPV project that does not change
the firm’s risk. What minimum NPV is required for this investment to benefit shareholders?
Solution
Recall that we can interpret BB’s equity as a four-year call option on the firm’s assets with a strike
price of $100 million. Given the current risk-free rate of 5.13%, asset value of $115 million, and
asset volatility of 25%, the current value of the equity call option is $40 million, with = 0.824.
If BB follows the risky strategy, the value of its assets will fall to $115 - 5 = $110 million,
and the volatility of the assets will increase to 35%. Applying the Black-Scholes formula with
these new parameters, we find the value of the equity call option would increase to $42.5 million,
or a $2.5 million gain for equity holders. Thus, leverage may cause equity holders to support
risky negative NPV decisions.
Second, suppose BB raises and invests I = $100,000 in a new project with NPV = V. Then
the value of the firm’s assets will increase by $100,000 + V. Because represents the sensitivity
of a call option to the underlying asset value, the value of equity will increase by approximately
times this amount, and so equity holders gain more than they invest if
(100,000 + V ) 7 100,000
Using Eq. 21.19 and Eq. 21.20, we can rewrite this condition as
NPV V 1 - bD D
= 7 =
I 100,000 bE E
which matches precisely Eq. 16.2. Using the betas from Example 21.10, we see that the investment
benefits shareholders only if its profitability index exceeds (0.14 * 75)/(1.2 * 40) = 0.21875, so
that the project’s NPV must exceed $21,875. Because equity holders may reject projects with a
positive NPV below this amount, the debt overhang induced by leverage may cause the firm to
underinvest.
Thus, option pricing methods can be used to assess potential investment distortions that
might arise due to debt overhang, or the incentive for asset substitution and risk-taking.
We can also use these methods to evaluate state-contingent costs, such as financial distress
costs.
In the above cases, management’s and equity holders’ option to default imposes costs on
the firm. But in many situations, having “options” when investing can be a good thing, and
enhance the value of the firm. We explore these situations in the next chapter.
Concept Check 1. How can we estimate the beta of debt?

2. The fact that equity is a call option on the firm’s assets leads to what agency costs?
21.1â•‡The Binomial Option Pricing Model

n An option can be valued using a portfolio that replicates the payoffs of the option in differ-
ent states. The Binomial Option Pricing Model assumes two possible states for the next time
period, given today’s state.
n The value of an option is the value of the portfolio that replicates its payoffs. The replicating
portfolio will hold the underlying asset and risk-free debt, and will need to be rebalanced over
time.
n The replicating portfolio for the Binomial Option Pricing Model is
Cu - Cd Cd - S d
= and B = (21.5)
Su - Sd 1 + rf
n Given the replicating portfolio, the value of the option is
C = S + B (21.6)
21.2â•‡The Black-Scholes Option Pricing Model

n The Black-Scholes option pricing formula for the price of a call option on a non-
dividend-paying stock is
C = S * N(d1) - PV(K ) * N(d2) (21.7)
where N(dâ•›â†œ) is the cumulative normal distribution and
MyFinanceLab 819
ln[S/PV(K )] s2T
d1 = +
s2T 2
d2 = d1 - s2T (21.8)
n Only five input parameters are required to price a call: the stock price, the strike price, the exer-
cise date, the risk-free rate, and the volatility of the stock. We do not need to know the expected
return on the stock to calculate the option price.
n The Black-Scholes option pricing formula for the price of a European put option on a non-
dividend-paying stock is
P = PV(K )[1 - N(d2)] - S[1 - N(d1)] (21.9)
n We can evaluate a European option on a stock that pays dividends using the Black-Scholes
formula with S x in place of S where
S x = S - PV(Div) (21.10)
If the stock pays a (compounded) dividend yield of q prior to the expiration date, then
S x = S/(1 + q) (21.11)
n The Black-Scholes replicating portfolio is
n For a call option on a non-dividend-paying stock
= N(d1) and B = - PV(K )N(d 2) (21.12)

n For a European put option on a non-dividend-paying stock
= - [1 - N(d1)] and B = PV(K )[1 - N(d2)] (21.13)
n The replicating portfolio must be continuously updated to remain tangent to the option
value
21.3â•‡Risk-Neutral Probabilities
n Risk-neutral probabilities are the probabilities under which the expected return of all securities
equals the risk-free rate. These probabilities can be used to price any other asset for which the
payoffs in each state are known.
n In a binomial tree, the risk-neutral probability r that the stock price will increase is given by
(1 + rf )S - Sd
r= (21.16)
S u - Sd
n The price of any derivative security can be obtained by discounting the expected cash flows
computed using the risk-neutral probabilities at the risk-free rate.
21.4â•‡Risk and Return of an Option

n The beta of an option can also be calculated by computing the beta of its replicating portfolio.
For stocks with positive betas, calls will have larger betas than the underlying stock, while puts
will have negative betas. The magnitude of the option beta is higher for options that are further
out of the money.
n The beta of an option is the beta of the underlying stock times the option’s leverage ratio:
S
b option = bS (21.17)
S + B
21.5â•‡ Corporate Applications of Option Pricing

n When debt is risky, the betas of equity and debt increase with leverage according to
D E
b E = ¢1 + ≤b , b D = (1 - )¢1 + ≤b U (21.19), (21.20)
E U D
M21_BERK0160_04_GE_C21.indd 819 8/20/16 11:51 AM

We can also use Eq. 21.19 to solve for the firm’s unlevered beta and debt beta, given an Â�estimate
of the beta and delta of the firm’s equity.
n Option valuation methods can be used to assess the magnitude of agency costs:
n As a result of debt overhang, equity holders benefit from new investment only if
NPV 1 - b D D
7 =
I bE E
verifying Eq. 16.2.
n Equity holders’ incentive to increase volatility can be estimated as the sensitivity of the value
of the equity call option to an increase in volatility.
Key Terms Binomial Option Pricing Model p. 790 martingale prices p. 809
binomial tree p. 790 Monte Carlo simulation p. 811
Black-Scholes Option Pricing Model p. 798 option delta p. 806
cumulative normal distribution p. 798 replicating portfolio p. 790
derivative security p. 811 risk-neutral probabilities p. 809
dynamic trading strategy p. 795 state prices p. 809
executive stock options (ESOs) p. 816 state-contingent prices p. 809
implied volatility p. 804 VIX index p. 805
leverage ratio (of an option) p. 812
Further The seminal article on options was written by Fischer Black and Myron Scholes: “The Pricing of
Options and Corporate Liabilities,” Journal of Political Economy 81 (1973): 637–654. It followed an
Reading earlier article by Robert Merton, “Theory of Rational Option Pricing,” Bell Journal of Economics and
Management Science 4 (1973): 141–183.
For a deeper discussion of options and other derivative securities, see: R. McDonald, Derivative
Â�Markets (Prentice Hall, 2006); J. Hull, Options, Futures, and Other Derivatives (Prentice Hall,
2008); R. Jarrow and S. Turnbull, Derivative Securities (South-Western, 1999); and P. Wilmott, Paul
Â�Wilmott on Quantitative Finance (John Wiley & Sons, 2006).
The following articles by Fischer Black contain an interesting account of the development of the
Black-Scholes formula as well as some of its limitations: “How We Came Up with the Option For-
mula,” Journal of Portfolio Management 15 (1989): 4–8; “The Holes in Black-Scholes,” RISK Maga-
zine 1 (1988): 30–33; and “How to Use the Holes in Black-Scholes,” Journal of Applied Corporate
Finance 1 (Winter 1989): 67–73.
For alternative methods of valuing employee stock options, see, for example, M. Rubinstein, “On the
Accounting Valuation of Employee Stock Options,” Journal of Derivatives (Fall 1995); J. Hull and
A. White, “How to Value Employee Stock Options,”Financial Analysts Journal 60 (2004): 114–119;
and N. Brisley and C. Anderson, “Employee Stock Option Valuation with an Early Exercise Bound-
ary,” Financial Analysts Journal 64 (2008): 88–100.
The use of option pricing methods to gain a deeper understanding of the role of agency costs in the
determination of optimal capital structure is developed in H. Leland, “Agency Costs, Risk Manage-
ment, and Capital Structure,” Journal of Finance (1998): 1213–1243.
Problems All problems are available in . An asterisk (*) indicates problems with a higher level of
difficulty.
The Binomial Option Pricing Model

1. The current price of Estelle Corporation stock is $25. In each of the next two years, this stock
price will either go up by 24% or go down by 24%. The stock pays no dividends. The one-year
Problems 821
risk-free interest rate is 8% and will remain constant. Using the Binomial Model, calculate the
price of a one-year call option on Estelle stock with a strike price of $25.
2. Using the information in Problem 1, use the Binomial Model to calculate the price of a one-
year put option on Estelle stock with a strike price of $25.
3. The current price of Natasha Corporation stock is $5.65. In each of the next two years, this
stock price can either go up by $2.50 or go down by $2. The stock pays no dividends. The
one-year risk-free interest rate is 3.2% and will remain constant. Using the Binomial Model,
calculate the price of a two-year call option on Natasha stock with a strike price of $7.
4. Using the information in Problem 3, use the Binomial Model to calculate the price of a two-
year European put option on Natasha stock with a strike price of $7.
5. Suppose the option in Example 21.1 actually sold in the market for $8. Describe a trading
strategy that yields arbitrage profits.
*6. Suppose the option in Example 21.2 actually sold today for $5. You do not know what the
option will trade for next period. Describe a trading strategy that will yield arbitrage profits.
7. Eagletron’s current stock price is $10. Suppose that over the current year, the stock price will
either increase by 102% or decrease by 56%. Also, the risk-free rate is 25% (EAR).
a. What is the value today of a one-year at-the-money European put option on Eagletron stock?
b. What is the value today of a one-year European put option on Eagletron stock with a strike
price of $20?
c. Suppose the put options in parts (a) and (b) could either be exercised immediately, or in one
year. What would their values be in this case?
8. What is the highest possible value for the delta of a call option? What is the lowest possible
value? (Hintâ†œæ¸€å±®: See FigureÂ€21.1.)
*9. Hema Corp. is an all equity firm with a current market value of $1340 million (i.e., $1.34 billion)
and will be worth $1206 million or $1876 million in one year. The risk-free interest rate is 5%.
Suppose Hema Corp. issues zero-coupon, one-year debt with a face value of $1407 million and
uses the proceeds to pay a special dividend to shareholders. Assuming perfect capital markets,
use the binomial model to answer the following:
a. What are the payoffs of the firm’s debt in one year?
b. What is the value today of the debt today?
c. What is the yield on the debt?
d. Using Modigliani-Miller, what is the value of Hema’s equity before the dividend is paid?
What is the value of equity just after the dividend is paid?
e. Show that the ex-dividend value of Hema’s equity is consistent with the binomial model.
What is the of the equity, when viewed as a call option on the firm’s assets?
*10. Consider the setting of Problem 9. Suppose that in the event Hema Corp. defaults, $90 million
of its value will be lost to bankruptcy costs. Assume there are no other market imperfections.
a. What is the present value of these bankruptcy costs, and what is their delta with respect to
the firm’s assets?
b. In this case, what is the value and yield of Hema’s debt?
c. In this case, what is the value of Hema’s equity before the dividend is paid? What is the value
of equity just after the dividend is paid?
The Black-Scholes Option Pricing Model

11. Roslin Robotics stock has a volatility of 35% and a current stock price of $60 per share. Roslin
pays no dividends. The risk-free interest is 5%. Determine the Black-Scholes value of a one-
year, at-the-money call option on Roslin stock.
12. Rebecca is interested in purchasing a European call on a hot new stock, Up, Inc. The call has
a strike price of $99 and expires in 92 days. The current price of Up stock is $119.16, and the
stock has a standard deviation of 42% per year. The risk-free interest rate is 6.25% per year.
a. Using the Black-Scholes formula, compute the price of the call.

b. Use put-call parity to compute the price of the put with the same strike and expiration date.
13. Using the data in TableÂ€ 21.1, compare the price on July 24, 2009, of the following options on
Â�JetBlue stock to the price predicted by the Black-Scholes formula. Assume that the standard devia-
tion of JetBlue stock is 64% per year and that the short-term risk-free rate of interest is 1.1% per year.
a. December 2009 call option with a $5 strike price
b. December 2009 put option with a $6 strike price
c. March 2010 put option with a $7 strike price
14. Using the market data in FigureÂ€20.10 and a risk-free rate of 0.25% per annum, calculate the
implied volatility of Google stock in September 2012, using the bid price of the 700 January
2014 call option.
15. Using the implied volatility you calculated in Problem 14, and the information in that problem,
use the Black-Scholes option pricing formula to calculate the value of the 800 January 2014 call
option.
16. Plot the value of a two-year European put option with a strike price of $20 on World Wide
Plants as a function of the stock price. Recall that World Wide Plants has a constant dividend
yield of 5% per year and that its volatility is 20% per year. The two-year risk-free rate of interest
is 4%. Explain why there is a region where the option trades for less than its intrinsic value.
17. Consider the at-the-money call option on Roslin Robotics evaluated in Problem 11. Suppose
the call option is not available for trade in the market. You would like to replicate a long posi-
tion in 1000 call options.
a. What portfolio should you hold today?
b. Suppose you purchase the portfolio in part a. If Roslin stock goes up in value to $62 per
share today, what is the value of this portfolio now? If the call option were available for trade,
what would be the difference in value between the call option and the portfolio (expressed as
percent of the value of the call)?
c. After the stock price change in part b, how should you adjust your portfolio to continue to
replicate the options?
18. Consider again the at-the-money call option on Roslin Robotics evaluated in Problem 11.
What is the impact on the value of this call option of each of the following changes (evaluated
separately)?
a. The stock price increases by $1 to $61.
b. The volatility of the stock goes up by 1% to 31%.
c. Interest rates go up by 1% to 6%.
d. One month elapses, with no other change.
e. The firm announces a $1 dividend, paid immediately.
Risk-Neutral Probabilities
19. Harbin Manufacturing has 10 million shares outstanding with a current share price of $23.58 per
share. In one year, the share price is equally likely to be $28 or $20. The risk-free interest rate is 5%.
a. What is the expected return on Harbin stock?
b. What is the risk-neutral probability that Harbin’s stock price will increase?
20. Using the information on Harbin Manufacturing in Problem 19, answer the following:
a. Using the risk-neutral probabilities, what is the value of a one-year call option on Harbin
stock with a strike price of $25?
b. What is the expected return of the call option?
c. Using the risk-neutral probabilities, what is the value of a one-year put option on Harbin
stock with a strike price of $25?
d. What is the expected return of the put option?
21. Using the information in Problem 1, calculate the risk-neutral probabilities. Then use them to
price the option.
Problems 823
22. Using the information in Problem 3, calculate the risk-neutral probabilities. Then use them to
price the option.
23. Explain the difference between the risk-neutral and actual probabilities. In which states is one
higher than the other? Why?
24. Explain why risk-neutral probabilities can be used to price derivative securities in a world where
investors are risk averse.
Risk and Return of an Option

25. Calculate the beta of the January 2010 $9 call option on JetBlue listed in the TableÂ€ 21.1.
Assume that the volatility of JetBlue is 64.7% per year and its beta is 0.86. The short-term risk-
free rate of interest is 1.29% per year. What is the option’s leverage ratio?
26. Consider the March 2010 $5 put option on JetBlue listed in TableÂ€21.1. Assume that the vola-
tility of JetBlue is 64.7% per year and its beta is 0.86. The short-term risk-free rate of interest is
1.29% per year.
a. What is the put option’s leverage ratio?
b. What is the beta of the put option?
c. If the expected risk premium of the market is 6%, what is the expected return of the put
option based on the CAPM?
d. Given its expected return, why would an investor buy a put option?
Corporate Applications of Option Pricing

27. Return to Example 20.11 (on page 780), in which Google was contemplating issuing zero-
coupon debt due in 16 months with a face value of $163.5 billion, and using the proceeds to
pay a special dividend. Google currently has a market value of $229.2 billion and the risk-free
rate is 0.25%. Using the market data in FigureÂ€20.10, answer the following:
a. If Google’s current equity beta is 1.2, estimate Google’s equity beta after the debt is issued.
b. Estimate the beta of the new debt.
*28. You would like to estimate the unlevered beta of Schwartz Industries (SI). SI’s value of out-
standing equity is $365.45 million, and you have estimated its beta to be 1.2. SI has four-
year zero-coupon debt outstanding with a face value of $200 million that currently trades for
$134.54 million. SI pays no dividends and reinvests all of its earnings. The four-year risk-free
interest rate is 5.13%. Use the Black-Scholes formula to estimate the unlevered beta of the firm.
*29. The J. Miles Corp. has 26 million shares outstanding with a share price of $18 per share. Miles
also has outstanding zero-coupon debt with a 5-year maturity, a face value of $890 million, and
a yield to maturity of 10%. The risk-free interest rate is 5%.
a. What is the implied volatility of Miles’ assets?
b. What is the minimum profitability index required for equity holders to gain by funding a
new investment that does not change the volatility of Miles’ assets?
c. Suppose Miles is considering investing cash on hand in a new investment that will increase
the volatility of its assets by 10%. What is the minimum NPV such that this investment will
increase the value of Miles’ shares?
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A01_GORD2302_01_SE_FM.indd 4 28/05/15 7:33 pm

C h a P t er
real Options 22
the MOSt IMpOrtaNt appLICatION OF OptIONS IN corporate N otation
finance is in the capital budgeting decision. Let’s use Amgen, a global biotechnology NPV net present value
company, as an example. Amgen had 2014 revenues of $20 billion, and it spent over
S x value of stock excluding
20% of its revenues on research and development. Even though only a very small num- dividends
ber of early-stage drug development projects ultimately reach the market, the ones that
S stock price
do can be highly successful. How does Amgen manage its research and development
PV present value
expenses to maximize value?
For Amgen, investing in R&D is like purchasing a call option. When research results on Div dividend
early-stage drug development projects are favorable, Amgen commits additional resources to K strike price
the next stage of product development. If research results are not promising, Amgen stops ln natural logarithm
funding the project. Amgen, by selectively investing in those technologies that prove to be
T years until the exercise
the most promising, exercises its option to develop a product: The additional investment date of an option
is equivalent to paying the strike price and acquiring the underlying asset—in this case,
s volatility of the return
the benefits of further product development. By choosing not to make further investments of the underlying asset
(thereby mothballing or abandoning the research and development project) Amgen chooses C call option price
not to exercise its option.
N(dâ†œæ¸€) cumulative normal
While real investment options like Amgen’s can be very important in capital budget- distribution
ing, the effect of such real options on the capital budgeting decision is generally appli-
r risk-neutral probability
cation specific, and no single methodology exists that applies across all settings. In light
rf risk-free rate of interest
of this fact, in this chapter we show how the general principles we have already developed
that govern capital budgeting and option pricing can be applied to evaluate real options
in the capital budgeting decision. We apply these principles to examine the three most
common options that occur in capital budgeting: the option to wait for the optimal time
to invest, the option to grow in the future, and the option to abandon a poorly perform-
ing project. We then consider two important applications: deciding the order in which to
complete a staged investment opportunity and deciding which of two mutually exclusive
projects of different lengths is the wiser investment. Finally, we explain rules of thumb
that managers often use to account for real options in the capital budgeting decision.
825
826 Chapter 22â•‡ Real Options
22.1 Real Versus Financial Options

The financial options we have studied in the previous two chapters give their holders the
right to buy, or sell, a traded asset such as a stock. Amgen’s option to invest in research
and development for new products is an example of a different type of option, called a real
option. A real option is the right to make a particular business decision, such as a capital
investment, after new information may be learned. A key distinction between a real option
and a financial option is that real options, and the underlying assets on which they are
based, are often not traded in competitive markets; for example, there is no market for
Amgen’s R&D in a particular drug.
Despite this distinction, many of the principles that we developed in the last two chapters for
financial options also apply to real options. In particular, because real options allow a decision
maker to choose the most attractive alternative after new information becomes available, the
presence of real options adds value to an investment opportunity. This value can be substantial,
especially in environments with a great deal of uncertainty. Thus, to make the most accurate
investment decisions, the value of these options must be included in the decision-making process.
Our approach to capital budgeting thus far has focused on the initial investment deci-
sion without explicitly considering future decisions that may be required over the life of
a project. Rather, we assumed that our forecast of the project’s expected future cash flows
already incorporated the effect of any future decisions made. In this chapter, we take a
closer look at how these cash flows, and therefore the NPV of a project, are determined
when a firm must react to changing business conditions over the life of a project. To do so,
we begin by introducing a new analytical tool called a decision tree.
Concept Check 1. What is the difference between a real option and a financial option?
2. Why does a real option add value to an investment decision?
22.2 Decision Tree Analysis

Most investment projects allow for the possibility of reevaluating the decision to invest at a
later point in time. Let’s illustrate this possibility with a natural example.
United Studios holds the movie rights for a national best-seller, and as part of these
rights also has the option to produce a sequel based on the same book. The studio is now
in the process of developing the production schedule. It believes that shooting both movies
simultaneously would allow significant cost savings, and both movies could be produced
for a total budget of $525 million. If instead the movies are produced sequentially, the
total expected cost will rise to $575 million. On the other hand, by waiting to produce the
second movie until after the first movie is released, the studio will have much better infor-
mation regarding the likely prospects for the sequel. Let’s see how we can use a decision tree
to analyze this situation.
First consider the case in which the movies are produced simultaneously. Once pro-
duced, the studio forecasts it will earn a total of $650 million from both movies, for a net
profit of $125 million.1 We illustrate this simple scenario in FigureÂ€22.1 using a decision
tree, a graphical representation that shows current and future decisions and their corre-
sponding risks and outcomes over time.
1
For simplicity, we ignore discounting in this example by assuming a zero interest rate and only idiosyn-
cratic risk. (Alternatively, we can interpret all amounts as their equivalent present values.) In later examples
we will incorporate discounting and systematic risk.
22.2â•‡ Decision Tree Analysis 827
Figure 22.1â•‡
Film I & II
United’s Investment Â�without 650 525 125
Real Options
This decision tree shows United’s
options if it produces both movies
Do Nothing
at once. The optimal decision is 0
shown in blue.
A decision tree differs from the binomial trees used in ChapterÂ€21. In a binomial tree,
the branches of the tree represent uncertainty that cannot be controlled. In a decision tree,
we also include branches to represent different choices available to the decision maker.
The decision tree in FigureÂ€22.1 is the decision tree for a standard investment problem
without real options. We can either invest, and earn the project’s NPV, or not invest and
earn 0. The square node indicates a decision point, where the decision maker must choose
which branch to follow. We highlight the optimal decision in blue; in this case United
Â�Studios would choose to invest and produce the movies since the expected payoff exceeds
the upfront cost: $650 million - $525 million = $125 million.
Representing Uncertainty
While United’s expected earnings imply that the movies are worth producing, there is
significant uncertainty regarding the actual outcome. In fact, the expected total revenue of
$650 million for both movies reflects two alternative outcomes. Based on the popularity of
the book, United believes there is a 50% chance the first movie will be a blockbuster suc-
cess, in which case the studio expects it will earn $500 million from it alone, and another
$400 million for the sequel. If instead the first film is just a moderate hit, it will only bring
in $300 million, and the sequel will only be expected to earn $100 million. We illustrate
this uncertainty in FigureÂ€22.2.
Notice that the decision tree now contains two kinds of nodes: square decision nodes
(invest versus do nothing), and circular information nodes in which uncertainty is resolved
that is out of the control of the decision maker (e.g., whether the film is a blockbuster or
not). FigureÂ€22.2 also indicates the point at which each cash flow is committed or realized.
Because the production cost is paid in advance, that cash flow is incurred before United
learns how successful the movies will be.
Figure 22.2â•‡
Blockbuster
Representing Uncertainty 50% 500 400
Circular nodes indicate the Film I & II
resolution of uncertainty. 525
Cash flows are shown at the 50% Moderate Hit
300 100
point they are committed
or resolved. Do Nothing
0
Real Options
The decision tree in FigureÂ€22.2 is not a full description of United’s alternatives. Instead of
producing the movies simultaneously, United can delay filming the sequel until after the
first movie is released.
United’s budget for the first film is $300 million. If it is only a moderate hit, they expect
to produce the sequel for $250 million. But if the first film is a blockbuster, the cost of the
second film will increase to $300 million (it will be worth investing more, and the actors
may demand higher wages). Overall, the expected total cost of producing the films sequen-
tially is $575 million, an increase of $50 million over the cost of filming them together.
We illustrate the decision tree for sequential production in FigureÂ€22.3. The key difference
between this figure and FigureÂ€22.2 is that we now illustrate the fact that United can wait
until it learns how successful the first movie is before deciding whether to produce the sequel.
A decision node that occurs after an information node in a decision tree is a real option. The
option to decide later is valuable because of the new information United will learn.
As FigureÂ€22.3 reveals, it is not optimal for United to produce the sequel unless the first
film is a blockbuster. Producing the sequel after a moderate success would cost $250 million
and earn only $100 million. Producing the sequel at that point has a negative NPV of –$150
million. Given United’s optimal strategy (shown in blue), its expected payoff is as follows:
Blockbuster, Moderate hit,
produce sequel no sequel
¸˚˚˚˚˚˚˚˚˚˚˚˝˚˚˚˚˚˚˚˚˚˚˚˛
- 300 + 50% * (500 - 300 + 400) + 50% * (300) = $150 million
Comparing this payoff to the expected payoff of $125 million if the movies are produced
simultaneously, the option to wait and decide later whether to produce the sequel is worth
$25 million to United. The option is valuable because United will learn enough informa-
tion to affect its decision: it will cancel the sequel if the first film is not a blockbuster. The
option value is equal to the benefit of avoiding a 50% chance of a loss of $150 million, or
$75 million, which exceeds the $50 million increase in expected production costs.
Solving Decision Trees

Many corporate investment decisions contain real options like the one facing United Stu-
dios. While the exact nature of these options is investment specific, they can be analyzed by
creating a decision tree that identifies
n Decision nodes showing the choices available at each stage
n Information nodes showing the payoff relevant information to be learned
n Investments made and payoffs earned over time
Figure 22.3â•‡
Film II
Blockbuster 400
United’s Investment 300
50% 500 0
with the Real Option to Film I Do Nothing
Produce Sequentially 300 Film II
50% Moderate Hit 100
If the movies are produced 250
sequentially, United can 300 0
make a more informed Film I & II Do Nothing
Â�decision whether to produce 125 (Figure 22.2 analysis)
the sequel.
22.3â•‡ The Option to Delay: Investment as a Call Option 829
Once the decision tree is created, we can value the investment opportunity by working
backward from the end of the tree. At each
(i) Decision node: determine the optimal choice by comparing the present value of
the remaining payoffs along each branch; and at each
(ii) Information node: compute the expected present value of the payoffs from the
subsequent branches.
As always, in both Steps (i) and (ii), we compute present values according to the Law of
One Price (using the methodologies developed in earlier chapters).
While our example here was highly simplified, with only two states and two choices, the
decision tree methodology is quite general and is used in practice to analyze highly complex
real world examples. We’ll consider a variety of real options in the remainder of this chapter.
Concept Check 1. How can you identify a real option in a decision tree?
2. In what circumstances does the real option add value?
3. How do you use a decision tree to make the best investment decision?
22.3 The Option to Delay: Investment as a Call Option

United Studios’ option to produce a movie sequel illustrates how choosing the optimal
time to make an investment can add value. This option to delay is common in practice.
Typically, there are costs from delaying the investment decision: interim profits from the
project are lost, costs might rise, competitors may enter, etc. On the other hand, by delay-
ing you will gain additional information regarding the value of the investment. In general,
one must trade off the costs from delay with the benefit from gaining information before
making a decision. In this section we see how the quantitative methods developed to price
financial options can be used to analyze the optimal timing decision.
An Investment Option
Consider the following investment opportunity. You have negotiated a deal with a major
electric car manufacturer to open a dealership in your hometown. The terms of the con-
tract specify that you must open the dealership either immediately or in exactly one year.
If you do neither, you lose the right to open the dealership at all. FigureÂ€22.4 shows these
choices on a decision tree.
Figure 22.4â•‡
0 1
Wait
Electric Car Â�Dealership $0 (Lose Rights)
Investment Opportunity
The electric car Â�dealership
must be opened either New
Â�immediately or in exactly one Wait Info.
Open in One Year NPV of Project
year. If we wait to open the in One Year
dealership, our decision can
be based on new informa-
tion about the dealership’s
value, which can take on many Open Today NPV of
values. Project Today
You are wondering how much you should pay for this opportunity. It will cost you $5
million to open the dealership, whether you open it now or in one year. If you open the
dealership immediately, you expect it to generate $600,000 in free cash flow the first year.
While future cash flows will vary with consumer tastes and the state of the economy, on
average these cash flows are expected to grow at a rate of 2% per year. The appropriate cost
of capital for this investment is 12%, so you estimate that the value of the dealership, if it
were open today, would be
$600,000
V= = $6 million (22.1)
12% - 2%
You also double-check this value using comparables. A publicly traded firm operating deal-
erships elsewhere in the state exists, and this firm provides an essentially perfect compa-
rable for your investment. This firm has an enterprise value equal to 10 times its free cash
flow, leading to an equivalent valuation.
Thus, the NPV of opening the dealership immediately is $1 million, implying that the
contract is worth at least $1 million. But given the flexibility you have to delay opening for
one year, should you be willing to pay more? And when should you open the dealership?
To answer these questions, we start at the end of the tree and evaluate the NPV of opening
the dealership in one year. If we wait, then one year from now we will have the choice to invest
$5 million to open the dealership, or lose our right to open it and receive nothing. Thus, at
that time, the decision is easy—we will open the dealership if its value at that time, based on
any new information about the economy and consumer tastes and trends, is above $5 million.
But because trends in this industry can change quickly, there is a great deal of uncertainty as to
what the expected cash flows and the value of the dealership will be at that time.
Next, to compute the present value at the information node, we can use the Law of One
Price. Our payoff if we delay is equivalent to the payoff of a one-year European call option
on the dealership with a strike price of $5 million. Because the final payoff in one year is
equivalent to a call option, we can use the techniques from ChapterÂ€21 to value it. Sup-
pose that the risk-free interest rate is 5%. We can estimate the volatility of the value of the
dealership by looking at the return volatility of the publicly traded comparable firm; sup-
pose this volatility is 40%. Finally, if we wait to open the dealership we will lose out on the
$600,000 in free cash flow we would have earned in the first year. In terms of a financial
option, this free cash flow is equivalent to a dividend paid by a stock—the holder of a call
option does not receive the dividend until the option is exercised. Let’s assume for now this
cost is the only cost of delay—there are no additional costs in terms of lost growth of the
dealership’s cash flows, for example.
TableÂ€22.1 shows how we can reinterpret the parameters for the Black-Scholes formula
for financial options to evaluate this real option to invest in the dealership. To apply the
Black-Scholes formula, recall from Eq. 21.10 that we must compute the current value of
the asset without the dividends that will be missed:
$0.6 million
S x = S - PV(Div) = $6 million - = $5.46 million
1.12
Note that we compute the present value of the lost cash flow using the project’s cost of
capital of 12%. Next, we need to compute the present value of the cost to open the dealer-
ship in one year. Because this cash flow is certain, we discount it at the risk-free rate:
$5 million
PV(K ) = = $4.76 million
1.05
Table 22.1 Black-Scholes Option Value Parameters for

Evaluating a Real Option to Invest
Financial Option Real Option Example
Stock Price S Current Market Value of Asset $6 million
Strike Price K Upfront Investment Required $5 million
Expiration Date T Final Decision Date 1 year
Risk-Free Rate rf Risk-Free Rate 5%
Volatility of Stock s Volatility of Asset Value 40%
Dividend Div FCF Lost from Delay $0.6 million
Now we can compute the value of the call option to open the dealership using Eq. 21.7
and Eq. 21.8:
ln[S x/PV(K )] s 2T ln(5.46/4.76)

d1 = + = + 0.20 = 0.543
s2T 2 0.40
d 2 = d1 - s 2T = 0.543 - 0.40 = 0.143
and therefore,
C = S xN(d1) - PV(K )N(d 2 )
= ($5.46 million) * (0.706) - ($4.76 million) * (0.557)
= $1.20 million (22.2)
The result in Eq. 22.2 states that the value today from waiting to invest in the dealer-
ship next year, and only opening it if it is profitable to do so, is $1.20 million. This value
exceeds the NPV of $1 million from opening the dealership today. Thus, we are better off
waiting to invest, and the value of the contract is $1.20 million.
What is the advantage of waiting in this case? If we wait, we will learn more about
the likely success of the business by observing the performance of the comparable firm.
Because our investment in the dealership is not yet committed, we can cancel our plans if
the popularity of electric cars should decline. By opening the dealership today, we give up
this option to “walk away.”2
Of course, there is a trade-off—if we wait to invest we give up the profits the dealer-
ship will generate the first year. Whether it is optimal to invest today will depend on the
magnitude of these lost profits, compared to the benefit of preserving our right to change
our decision. To see this trade-off, suppose instead that the first-year free cash flow of
the dealership is projected to be $700,000, so that the current value of the dealership is
$7Â€Â�million (using the 10x multiple of the comparable, or a similar calculation to Eq. 22.1).
In this case, the same analysis shows that the value of the call option would be $1.91 mil-
lion. Because the value of opening the dealership today is $7 million - 5 million = $2
million, in this case it would not be optimal to wait, and we would open the dealership
immediately.
2
A second benefit from waiting is that the cost of opening the dealership is assumed to stay the same
($5 million), so the present value of this cost declines if we wait. This benefit is specific to the example.
Depending on the scenario, the cost of investing may rise or fall over time.
Why Are There Empty Lots in Built-Up Areas of Big Cities?

Have you ever wondered why there are empty lots (for waiting might exceed the net present value of building
example, a parking lot) right next to multi-story buildings in today.*
a city? After all, if it was optimal for the next-door neighbor Notice a similar effect in the price of agricultural land
to build a multi-story building, why would someone choose that is close to big cities. Even though the land might pro-
to leave the lot empty? In many cases, the property taxes duce the same agricultural revenue as similar land 100 miles
exceed the revenue generated by the empty lot, so by putting away, the price of the land closer to the city is higher because
a revenue-producing building on the lot, the owner could the price reflects the possibility that the city might grow
turn a negative cash flow into a positive cash flow. However, to the point that it becomes economical to put the land to
by building on the lot, the owner gives up the option to non-agricultural use—that is, subdivide it and build single-
construct a different building in the future. If there is a large family housing. The option to one day use the land in this
amount of uncertainty about the kind of building to put on way is reflected in the current price of the land.
the lot, and if this uncertainty might be resolved in the
future, it might make sense to wait for additional informa- *S. Titman, “Urban Land Prices Under Uncertainty,” American Eco-
tion before breaking ground on a building. The value of nomic Review 75 (1985): 505–514, develops this idea.
FigureÂ€22.5 plots the NPV of investing today and the value of waiting as we vary the
expected first-year free cash flow of the dealership, and thus its current operating value.
As the figure makes clear, you should invest today (and give up the option to wait) only
if the current value of the dealership exceeds $6.66 million. Thus, your optimal invest-
ment strategy is to invest today only if the NPV of the investment opportunity exceeds
$6.66 million - 5 million = $1.66 million.
Figure 22.5â•‡
3.0
The Decision to Invest
Value of
in the Dealership Waiting
The red line denotes the 2.5
NPV of investing today. The
yellow curve shows the value Value of
2.0
Value (in $ million)
today of Â�waiting one year Contract

to make the decision (i.e.,
the value of the call option).
1.5
The black curve indicates
the value of the contract,
Value of
which gives us the option 1.0 Investing Today
to invest today, in one year,
or not at all. The optimal
investment strategy is to 0.5 Wait Invest Today
invest today only if the value
of an operating
Â� dealership
exceeds $6.66 million. 0.0
2 3 4 5 6 6.66 7 8
Current Value of an Operating Dealership (in $ million)
Factors Affecting the Timing of Investment

This example illustrates how the real option to wait affects the capital budgeting decision.
Without the option of when to invest, it is optimal to invest as long as NPV 7 0. But when
you have the option of deciding when to invest, it is usually optimal to invest only when the
NPV is substantially greater than zero.
To understand this result, think of the timing decision as a choice between two Â�mutually
exclusive projects: (1) invest today or (2) wait. Faced with mutually exclusive choices, we
should choose the project with the higher NPV. That is, we should invest today only if the
NPV of investing today exceeds the value of the option of waiting. If we can always walk
away from the project, the option of waiting will be positive, so the NPV of investing today
must be even higher for us to choose not to wait.
An interesting aspect of the dealership investment opportunity is the value of the deal
when the ongoing value of a dealership is less than $5 million. In this case, the NPV of
opening a dealership is negative, so without the option to wait the investment opportunity
is worthless. But from FigureÂ€22.5 we see that, with the option to wait, the investment
opportunity is clearly not worthless. Even if the current value of an electric car dealership
is $4 million (which means the NPV of investing today is - $1 million), the value of the
opportunity is still worth about $248,000. That is, you would still be willing to pay up to
$248,000 to sign the deal. Thus, given the option to wait, an investment that currently has a
negative NPV can have a positive value.
Aside from the current NPV of the investment, what other factors affect the value of an
investment and the decision to wait? From FigureÂ€22.5 we can see that factors that increase
the value of the call option will increase the benefit of waiting. Recall from our study of
financial options in ChaptersÂ€20 and 21 that both the volatility and the dividends of the
stock affect the value of a call option and the optimal time to exercise the call. These factors
have their counterparts for real options:
n Volatilityâ†œ:â•‡ By delaying an investment, we can base our decision on additional infor-
mation. The option to wait is most valuable when there is a great deal of uncertainty
regarding what the value of the investment will be in the future. If there is little uncer-
tainty, the benefit of waiting is diminished.
n Dividendsâ†œ:â•‡ Recall that absent dividends, it is not optimal to exercise a call option early.
In the real option context, the dividends correspond to any value from the investment
that we give up by waiting. It is always better to wait unless there is a cost to doing so.
The greater the cost, the less attractive the option to delay becomes.
Example 22.1 Evaluating the Decision to Wait
Problem
Suppose your current estimate of the electric car dealership’s value is $6 million. What would
be the value of the dealership contract if the volatility of the dealership’s value were 25% rather
than 40%? Alternatively, suppose the volatility is 40%, but waiting would lead competitors to
expand and reduce the future free cash flows of the dealership by 10%. What is the value of the
contract in this case?
Solution
With a lower volatility of 25%, we have
ln[S x/PV(K )] s2T ln(5.46/4.76)

d1 = + = + 0.125 = 0.674
s2T 2 0.25
d 2 = d1 - s2T = 0.674 - 0.25 = 0.424
The value of the call option is
C = S xN(d 1) - PV(K )N(d2)
= ($5.46 million) * (0.750) - ($4.76 million) * (0.664)
= $0.93 million
Therefore, it is better to invest immediately and get an NPV of $1 million, rather than wait.
With the lower volatility, not enough information will be learned over the next year to justify the
cost of waiting.
Now let’s suppose the volatility is 40%, but waiting leads to increased competition. In this
case, we should deduct the loss from increased competition as an additional “dividend” that we
forego by waiting. Thus,
S x = S - PV(First@Year FCF) - PV(Lost FCF from Competition)
$0.6 million
= ¢$6 million - ≤ * (1 - 0.10) = $4.92 million
1.12
Now,
ln[S x/PV(K )] s2T ln(4.92/4.76)

d1 = + = + 0.20 = 0.283
s2T 2 0.40
d2 = d 1 - s2T = 0.283 - 0.40 = 0.117
The value of the call option in this case is
C = S xN(d1) - PV(K )N(d2)
= ($4.92 million) * (0.611) - ($4.76 million) * (0.453)
= $0.85 million
Again, it would not be optimal to wait. In this case, despite the information to be gained, the
costs associated with waiting are too high.
Investment Options and Firm Risk

Imagine that you formed a corporation and, acting on behalf of this corporation, you
signed the electric car dealership contract. If the corporation has no other assets, what is the
value of the corporation and how risky is it?
We have already calculated the value of the contract as a real option. Indeed, when the
value of an operating dealership is $6 million, the contract—and thus your firm—is worth
$1.2 million. To assess risk, you note that electric car dealerships are very sensitive to the
economy and have a beta of about 2. Your firm, however, will not begin operating the
Global Financial Crisis Uncertainty, Investment, and the Option to Delay
In mid-September 2008, with the markets for investment buy troubled assets and effectively signal the government’s
capital frozen, the Treasury announced an unprecedented intention to stabilize markets. By stabilizing markets and
program to help unfreeze credit markets and stave off a deep reducing uncertainty, it was hoped that TARP would help
recession. The well-founded worry was that the dysfunc- stimulate investment.
tional financial markets would effectively cut off business Unfortunately, however, TARP failed in its primary
activity and thus precipitate a crash in the real economy. mission to decrease uncertainty. Indeed, concerns about
Despite the passage of a $750 billion relief program (the whether the program would be implemented and how it
Troubled Asset Relief Program—TARP), the economy would be implemented contributed significantly to overall
plunged into the deepest recession since the Great Depres- uncertainty in the economy, making the option to delay
sion. What went wrong? investment until the uncertainty was resolved more valu-
One likely factor was lawmakers’ insensitivity to the able. In the end, the combination of this increased uncer-
effect of uncertainty on the real option to delay invest- tainty together with a gloomy economic forecast led to a
ment. The original idea behind TARP was to reduce 19.1% decline in business investment in the fourth quarter
uncertainty by making a huge capital commitment to of 2008, the largest decline since 1975.
dealership immediately; instead, it will wait until next year to decide whether to invest. The
beta of your firm will therefore equal the beta of the option on a dealership, which we can
calculate using the Black-Scholes formula and Equation 21.17 from the last chapter. Given
the $6 million value of the operating dealership, and using the values from Eq. 22.2, the
beta of the option to open the dealership—and therefore the beta of the corporation—is
S x * N(d1) ($5.46 million) * (0.706)

bcorp = bdealer = bdealer = 3.2 * bdealer = 6.4
C $1.2 million
Notice that the beta of a corporation with the option to open a dealership (that is, 6.4)
is considerably larger than the beta of a dealership itself (2.0). Moreover, the beta of the
corporation will fluctuate with the value of the option, and it will only be equal to the beta
of a dealership if it is optimal to open the dealership immediately.
As this example shows, when comparing firms in the same industry, betas may vary
depending upon the firms’ growth opportunities. All else equal, firms for which a higher
fraction of their value depends on future growth will tend to have higher betas.3
The fact that the beta of the firm includes the beta of the firm’s growth options has impli-
cations for capital budgeting. Because the beta of growth options tend to be higher than the
beta of the firm’s investments in place, the beta of the firm typically overstates the beta of its
existing assets. Hence, when financial analysts estimate an individual project beta by using the
beta of a firm with substantial growth options, they may be overestimating the project beta.4
Concept Check 1. What is the economic trade-off between investing immediately or waiting?
2. How does the option to wait affect the capital budgeting decision?
3. Does an option to invest have the same beta as the investment itself?
3
The apparent failure of the CAPM to explain the cross-section of stock returns has been at least par-
tially attributed to ignoring the effect of future investment options on the beta of the firm—see Z. Da,
R.Â€J.Â€Guo, and R. Jagannathan, “CAPM for estimating the cost of equity capital: Interpreting the empiri-
cal evidence,” Journal of Financial Economics 103 (2012): 204–220.
4
For an analysis of this potential bias and an approach to correct it, see A. Bernardo, B. Chowdhry, and
A.Â€Goyal, “Assessing Project Risk,” Journal of Applied Corporate Finance 24 (2012): 94–100.
22.4 Growth and Abandonment Options

When a firm has a real option to invest in the future, as in the dealership example, it is
known as a growth option. In other situations, the firm may have the option to reduce the
scale of its investment in the future; the option to disinvest is known as an abandonment
option. Because these options have value, they contribute to the value of any firm with
future possible investment opportunities.
Valuing Growth Potential

Future growth opportunities can be thought of as a collection of real call options on poten-
tial projects. Out-of-the-money calls are riskier than in-the-money calls, and because most
growth options are likely to be out-of-the-money, the growth component of firm value is
likely to be riskier than the ongoing assets of the firm. This observation might explain why
young firms (and small firms) have higher returns than older, established firms. It also
explains why R&D-intensive firms often have higher expected returns even when much of
the R&D risk is idiosyncratic.5
In the dealership example, the main source of uncertainty was the investment’s expected
cash flows. Let’s consider a second example of a growth option in which the uncertainty is
instead about the investment’s cost of capital. In this case, we will also illustrate how to value
the option using the technique of risk-neutral probabilities introduced in ChapterÂ€21.6
StartUp Incorporated is a new company whose only asset is a patent on a new drug. If
produced, the drug will generate certain profits of $1 million per year for the life of the
patent, which is 17 years (after that, competition will drive profits to zero). It will cost $10
million today to produce the drug. Assume that the yield on a 17-year risk-free annuity is
currently 8% per year. What is the value of the patent?
Using the formula for the present value of an annuity, the NPV of investing today in
the drug is
1 1
NPV = ¢1 - ≤ - 10 = - $878,362
0.08 1.0817
Based on this calculation, it does not make sense to invest in the drug today. But what if inter-
est rates change? Let’s assume that interest rates will change in exactly one year. At that time,
all risk-free interest rates will be either 10% per year or 5% per year, and then will remain at
that level forever. Clearly, an increase in interest rates will make matters worse. Because interest
rates will remain at the new higher level forever, it will never be optimal to invest. Thus, the
value of this growth option is zero in that state. However, if rates drop, the NPV of undertak-
ing the investment, given that the patent will have a remaining life of 16 years, is
1 1
NPV = ¢1 - ≤ - 10 = $837,770
0.05 1.0516
In this case, it is optimal to invest. We can put this information on a decision tree, as
shown in FigureÂ€22.6.
5
Readers interested in a more in-depth discussion of the relation between R&D risk and returns can con-
sult J. Berk, R. Green, and V. Naik, “The Valuation and Return Dynamics of New Ventures,” Review of
Financial Studies 17 (2004): 1–35.
6
Using risk-neutral probabilities in a decision tree is more general than Black-Scholes, which assumes a log-
normal distribution for the asset’s value and that the option can only be exercised at a fixed point in time.
22.4â•‡ Growth and Abandonment Options 837
Figure 22.6â•‡
0 1
StartUp’s Decision to Invest
Negative NPV
Invest in the Drug Rates Rise
If interest rates rise, it
does not make sense to Don’t Invest
NPV $0
invest. If rates fall, it is
optimal to develop the Invest
NPV $837,770
drug.
Rates Fall
Don’t Invest
NPV $0
Working back to the information node at time zero, we face two outcomes, $0 if rates rise
and $837,770 if rates fall. While we don’t know the true probability of each outcome, we can
compute the present value using risk-neutral probabilities as we showed in Chapter 21. To
find the risk-neutral probabilities, we solve for the probabilities so that the expected return of
all financial assets is equal to the current risk-free rate. In ChapterÂ€21, we used a stock as the
financial asset; in this case, we use the 17-year risk-free annuity that pays $1000 per year as
the financial asset. The value today of this annuity is
1000 1
S= ¢1 - ≤ = $9122
0.08 1.0817
A year from now, the annuity will pay $1000, and it will have 16 years left to maturity.
Therefore, including the payment, it will be worth either
1000 1
Su = 1000 + ¢1 - 16 ≤ = $8824
0.1 1.1
if interest rates go up, or, if interest rates fall,
1000 1
Sd = 1000 + ¢1 - ≤ = $11,838
0.05 1.0516
Suppose the current one-year risk-free interest rate is equal to 6%. (Note that this rate
is below the current 17-year annuity rate of 8%; thus, the current yield curve is upward-
sloping.) We can calculate the risk-neutral probability of interest rates increasing, which we
denote by r using Eq. 21.16:
(1 + rf )S - Sd 1.06 * 9122 - 11,838

r= = = 71.95%
S u - Sd 8824 - 11,838
That is, a risk-neutral probability of 71.95% that interest rates will rise is required for the
annuity to have an expected return equal to the risk-free rate of 6% over the next year.
Now that we have calculated the risk-neutral probabilities for the interest rate move-
ments, we can use them to value StartUp’s patent. The value today of the investment
opportunity is the present value of the expected cash flows (using risk-neutral probabilities)
discounted at the risk-free rate:
837,770 * (1 - 0.7195) + 0 * 0.7195

PV = = $221,693
1.06
In this example, even though the cash flows of the project are known with certainty, the
uncertainty regarding future interest rates creates substantial option value for the firm. The
firm’s ability to use the patent and grow should interest rates fall is worth close to a quarter
of a million dollars.
The Option to Expand

Future growth options are not only important to firm value, but can also be important
in the value of an individual project. By undertaking a project, a firm often gets the
Â�opportunity to invest in new projects that firms outside the industry cannot easily access.
For example, a fashion designer might introduce a new line of clothes knowing that if the
line proves popular, he has the option to launch a new line of accessories based on those
clothes.
Consider an investment opportunity with an option to grow that requires a $10 million
investment today. In one year, we will find out whether the project, which entails introduc-
ing a new product into the business machines market, is successful. The risk-neutral prob-
ability that the project will generate $1 million per year in perpetuity is 50%; otherwise,
the project will generate nothing. At any time, we can double the size of the project on the
original terms. FigureÂ€22.7 represents these decisions on a decision tree.
Assume that the risk-free rate is constant at 6% per year. If we ignore the option
to double the size of the project and we invest today, then the expected cash flows are
$1 million * 0.5 = $500,000 per year. Computing the NPV gives
500,000
NPVwithout growth option = - 10,000,000 = - $1.667 million
0.06
Based on this analysis, it appears that it is not optimal to undertake the project today. Of
course, that also means we will never find out whether the project is successful.
Figure 22.7â•‡
0 1 2 3
Staged Investment Double Size ...
Opportunity Success
At any time, the size of the proj- ...
Invest
ect can be doubled on the origi- Same Size
nal terms. It is optimal
Â� to make Fail
this decision after we find out
whether the project is a success.
This growth option can make the Don’t Invest
initial investment worthwhile.
Scott Mathews, formerly a Technical Fel- Interview With

QUESTION: Explain the concepts of “pilot”
low with the Computational Finance and
Â�Stochastic Modeling team within Boeing’s
Â�
Scott Mathews and “commercial” stages?
ANSWER: The “pilot” stage refers to the
advanced research and development
Â�
incremental staged investments we make
division. He has expertise in “Business
to move projects through “decision gates,”
Engineering,” a Â�technology that features
investing a small and appropriate amount
complex financial and investment risk
to gather information about the technology
models applying real asset option pricing
and the market, while driving down the
for new products and strategically signifi- project risks. At the end of each decision
cant projects. Mr. Mathews has a number gate, the project is re-evaluated. If there is
of patents in the field of real options. a reasonable weighted probability of a suc-
cessful outcome, we invest again and con-
tinue to the next decision gate. Projects go
through several gates, and at each one we
QUESTION: How can real options be used focus on reducing uncertainty, until arriv-
to manage projects? ing at a decision point of whether to make
a large, discretionary, one-time invest-
ANSWER: High-potential projects typi-
ment (the “strike price”) that launches the
cally have substantial uncertain cash
“piloted” concepts into production—the
flows owing to technology and market
“commercial” stage—or terminate the project.
uncertainties, and therefore your corporate finance team
has to be more active in managing these projects. Essen-
QUESTION: How does staging development create a real
tially they act as internal venture capitalists, seeking high
option with value?
payoffs from risky projects. We use real options to evaluate
these types of investment opportunities. With real options, ANSWER: Staging development is how we use real options
we can answer the questions: Given the technical and mar- to manage projects. By staging development we are buying
ket risks of the project, how much should we spend at the knowledge, especially about the project risks and opportu-
early stages? Does each incremental investment increase nities. As a project moves through gates, projects compete
my return opportunities or decrease risk, and how? What for funding, and we use this knowledge to decide which
amount of technology and market “learning” must be projects should proceed and which ones should be deferred.
accomplished to merit a follow-on investment? The approach brings together the engineering, marketing,
Real options are call options on an opportunity, giving and finance disciplines to give a uniform look at risks and
you the right to stop, start, or modify a project at some investment opportunities. This is one of the huge powers of
future date. They are contingent, so you can make a stra- the technique.
tegic, rather than tactical, investment. By investing a small Boeing’s ability to solve aviation challenges with a high
amount at each stage, you can gather enough information degree of efficiency is our competitive advantage and allows
to decide what to do next. This limits your losses but still us to “buy” these options at below their market value
lets you capitalize on opportunities that arise. You don’t through investments (the “premium”) in our engineering
reject (or approve) the project outright, but make incre- processes. Buying an option for less provides direct value to
mental investments in the technology or market to gather shareholders. We can leverage our internal knowledge with
sufficient information to determine whether this invest- a relatively small amount of money and hedge the risks. It’s
ment optimizes the company’s strategy and produces posi- a tricky process, and is not completely financial. It often
tive returns over the long term. requires judgment as well.
Consider undertaking the project and exercising the growth option to double the size
in a year if the product takes off. The NPV of doubling the size of the project in a year in
this state is
1,000,000
NPVdoubling if successful = - 10,000,000 = $6.667 million
0.06
The risk-neutral probability that this state will occur is 50%, so the expected value of this
growth option is 6.667 * 0.5 = $3.333 million. The present value of this amount today is
3.333
PVgrowth option = = $3.145 million
1.06
We have this option only if we choose to invest today (otherwise, we never find out
how the product performs), so the NPV of undertaking this investment is the NPV we
calculated above plus the value of the growth option we obtain by undertaking the project:
NPV = NPVwithout growth option + PVgrowth option
= - 1.667 + 3.145 = $1.478 million
Our analysis shows that the NPV of the investment opportunity is positive and the firm
should undertake it.
Notice that it is optimal to undertake the investment today only because of the exis-
tence of the future expansion option. If we could find out how well the product would sell
without actually producing it, then it would not make sense to invest until we found out
this information. Because the only way to find out if the product is successful is to make
and market it, it is optimal to proceed. In this case, the project is viable because we can
experiment at a low scale and preserve the option to grow later.
This project is an example of a strategy that many firms use when they undertake big
projects. Rather than commit to the entire project initially, a firm experiments by under-
taking the project in stages. It implements the project on a smaller scale first; if the small-
scale project proves successful, the firm then exercises the option to grow the project.
The Option to Abandon

The previous two examples consider cases in which the firm has the option to grow or
expand if the project proves successful. Alternatively, when a project is unsuccessful, the
firm may be able to mitigate its loss by abandoning the project. An abandonment option is
the option to walk away. Abandonment options can add value to a project because a firm
can drop a project if it turns out to be unsuccessful.
To illustrate, assume you are the CFO of a publicly traded nationwide chain of gourmet
food stores. Your company is considering opening a new store in the renovated Ferry Build-
ing in Boston. If you do not sign the lease on the store today, someone else will, so you will
not have the opportunity to open a store later. There is a clause in the lease that allows you
to break the lease at no cost in two years.
Including the lease payments, the new store will cost $10,000 per month to operate.
Because the building has just recently reopened, you do not know what the pedestrian traf-
fic will be. If your customers are mainly limited to morning and evening commuters, you
expect to generate $8000 per month in revenue in perpetuity. If, however, the building fol-
lows the lead of the Ferry Building in San Francisco and becomes a tourist attraction, you
believe that your revenue will be double that amount. You estimate there is a 50% prob-
ability that the Ferry Building will become a tourist attraction. The costs to set up the store
will be $400,000. Assume that the cost of capital for the business is 7% per year.
Whether the Boston Ferry Building becomes a tourist attraction represents idiosyncratic
uncertainty that investors in your company can costlessly diversify, and hence we do not
need to adjust its probability for risk (i.e., the risk-neutral probability equals the true prob-
ability of 50%). If you were forced to operate the store under all circumstances, then the
expected revenue will be $8000 * 0.5 + $16,000 * 0.5 = $12,000. Given the monthly
discount rate of 1.071/12 - 1 = 0.565%, the NPV of the investment is
12,000 - 10,000
NPV = - 400,000 = - $46,018
0.00565
It would not make sense to open the store.
Of course, you do not have to keep operating the store. You have an option to get out of
the lease after two years at no cost, and after the store is open it will be immediately obvi-
ous whether the Ferry Building is a tourist attraction. In this case, the decision tree looks
like FigureÂ€22.8.
If the Ferry Building is a tourist attraction, the NPV of the investment opportunity is
16,000 - 10,000
NPV = - 400,000 = $661,947
0.00565
If the Ferry Building does not become a tourist attraction, you will close the store after
two years. The NPV of the investment opportunity in this state is just the NPV of operat-
ing for two years:
8000 - 10,000 1
NPV = ¢1 - ≤ - 400,000
0.00565 1.0056524
= - $444,770
There is an equal probability of each state and again, because the risk is idiosyncratic,
the actual and risk-neutral probabilities are the same. Thus, the NPV of opening the store
is just the expected value using the actual probabilities:
$661,947 * 0.5 - $444,770 * 0.5 = $108,589
By exercising the option to abandon the venture, you limit your losses and so the NPV of
undertaking the investment is positive. The value of the option to abandon is the difference
between the NPV with and without the option: 108,589 - ( - 46,018) = $154,607.7
Figure 22.8â•‡
0 1 ... 24
Decision to Open a Store in
Tourist Keep Operating
the Boston Ferry Building
Attraction ...
You must decide now whether
Shut Down
to sign the lease and open the Open
store, but you have an option to Not Tourist Keep Operating
abandon the lease in 24 months Attraction
...
(2 years). The profitability of the Shut Down
store depends on whether the Do Nothing
Ferry Building becomes a Â�tourist
attraction.
7
We can also calculate the option value directly; with a 50% probability, we avoid the losses of $2000 per
month starting in two years:
1 2000
50% * * = $154,607
1.0056524 0.00565
It is easy to ignore or understate the importance of the option to abandon. In many

applications, killing an economically unsuccessful venture can add more value than starting
a new venture. Often, however, managers focus on the value created by starting new ven-
tures and de-emphasize the value created by abandoning old ventures. Some of this behav-
ior undoubtedly results from the same behavioral biases that we discussed in Â�ChapterÂ€13
that cause individual investors to hold onto losers. It is also closely tied to the sunk cost
fallacy, the idea that once a manager makes a large investment, he should not abandon a
project. As we pointed out in ChapterÂ€8, sunk costs should have no bearing on an invest-
ment decision. If continuing a project is a negative-NPV undertaking, you can create value
by abandoning, regardless of how much investment has already been sunk into the project.
Concept Check 1. Why can a firm with no ongoing projects, and investment opportunities that currently have nega-
tive NPVs, still be worth a positive amount?
2. Why is it sometimes optimal to invest in stages?
3. How can an abandonment option add value to a project?
22.5 Investments with Different Lives

As we have seen, real options can add substantial value to an investment decision. There-
fore, when we are in a position of choosing between alternative investments, it is neces-
sary to assess any differences in the real options each provides. One example that can be
particularly important is the case where one is comparing investments with different lives.
While longer-term investments may have cost or return advantages, shorter-term invest-
ments include reinvestment options that should not be ignored. Let’s illustrate this trade-off
with an example.
Consider the following problem faced by a financial analyst at Canadian Motors. Last
year, an engineering firm named Advanced Mechanics was asked to design a new machine
that will attach car chassis to bodies. The firm has produced two designs. The cheaper
design will cost $10 million to implement and last five years. The more expensive design
will cost $16 million and last 10 years. In both cases, the machines are expected to save
Canadian Motors $3 million per year. If the cost of capital is 10%, which design should
Canadian Motors approve?
Standalone NPV of Each Design.â•‡ Let’s first calculate the NPV of each decision on a
standalone basis. The NPV of adopting the five-year machine is
3 1
NPV5 yr = ¢1 - ≤ - 10 = $1.37 million
0.10 1.105
The NPV of the 10-year machine is
3 1
NPV10 yr = ¢1 - ≤ - 16 = $2.43 million
0.10 1.1010
If the analyst simply picked the design with the higher standalone NPV, he would
choose the longer-lived design. However, the preceding NPV calculation ignores the dif-
ference in these projects’ life spans. The longer-lived design embodies a 10-year production
plan. The shorter-lived design only captures what will happen over the next five years. To
truly compare the two options, we must consider what will happen once the shorter-lived
equipment wears out. Let’s consider three possibilities: (1) the technology is not replaced;
22.5â•‡ Investments with Different Lives 843
(2) it is replaced at the same terms; or (3) technological advances allow us to replace it at
improved terms.
No Replacement.â•‡ If the shorter-lived technology is not replaced (and the firm reverts to
its old production process), there will be no additional benefits once its five-year life ends.
In that case, the original comparison is correct, and the 10-year machine will increase firm
value by 2.43 - 1.37 = $1.06 million more than the shorter-lived design.
One reason we might not replace the technology is if we expect its cost to increase. For
example, suppose its cost in five years’ time will be $11.37 million or higher (an increase of
2.6% per year). In that case, because the cost of the machine has gone up by more than its
current NPV of $1.37 million, replacement will not be optimal.
Replacement at the Same Terms.â•‡ Suppose that we expect the costs and benefits of the
shorter-lived design to be the same in five years. In that case, it will be optimal to replace the
machine with a new equivalent machine, as we will again earn its NPV of $1.37 million.
We should include this benefit when we evaluate the NPV of the five-year design, leading
to a total NPV over the 10-year horizon of
1.37
NPV5 yr, with replacement = 1.37 + = $2.22 million
1.105
Allowing for replacement at the same terms substantially increases the NPV we calcu-
lated for the five-year design. However, it is still inferior to the $2.43 million NPV from
the 10-year design.
Replacement at Improved Terms.â•‡ In reality, the future cost of a machine is uncertain.
Because of technological advances, machines may become less expensive rather than more
expensive (think about the steadily declining prices of computers). Suppose we expect the
cost of the new technology to fall to $7 million at the end of five years. Because the cost
Equivalent Annual Benefit Method
Traditionally, managers have accounted for the difference Thus, the 10-year machine has the higher equivalent annual
in project lengths by calculating the equivalent annual benefit and would be chosen under this method.
benefit (EAB) of each project, which is the constant annu- The equivalent annual benefit method assumes that we
ity payment over the life of the project that is equivalent earn the project’s EAB over the entire forecast horizon. For
to receiving its NPV today. The equivalent annual benefit the five-year machine, this assumption means that we would
method then selects the project with the highest equivalent earn an NPV over 10 years of
annual benefit. (When all cash flows are costs, this approach
is sometimes referred to as the equivalent annual cost 0.361 1
method.) NPV5 yr EAB = ¢1 - ≤ = $2.22 million
0.10 1.1010
For example, in the case of Canadian Motors, the equiva-
lent annual benefit of each machine is Comparing this result with our earlier analysis, we see that
1.37 using the EAB method is equivalent to assuming that we can
EAB5 yr = = $0.361 million, replace the project at identical terms over the entire horizon.
1 1
¢1 - ≤ While this assumption may be correct, in most instances
0.10 1.105 there is significant uncertainty regarding the project terms
2.43 in the future. In that case, real option methods must be used
EAB10 yr = = $0.395 million to determine the correct choice.
1 1
¢1 - ≤
0.10 1.1010
has declined by $3 million, its NPV will rise to 3 + 1.37 = $4.37 million. In that case, the
NPV of the five-year design over a 10-year horizon is
4.37
NPV5 yr, with improved replacement = 1.37 + = $4.08 million
1.105
Thus, if terms are expected to improve in this way, the five-year design is optimal for
the firm, increasing firm value by 4.08 - 2.43 = $1.65 million compared to the 10-year
machine.
Valuing the Replacement Option.â•‡ As the above analysis reveals, adopting the five-year
machine provides the firm with a replacement option in five years’ time. In order to com-
pare the two designs correctly, we must determine the value of this replacement option,
which will depend on the likelihood that the cost of the machine will decrease or increase.
Example 22.2 Valuing the Replacement Option
Problem
Suppose the cost of the shorter-lived machine is equally likely to rise to $13 million, stay equal to
$10 million, or fall to $7 million, and suppose this risk is idiosyncratic and does not change the
project’s cost of capital. Which machine should the firm choose?
Solution
If the cost rises to $13 million, the firm will choose not to replace the machine and get an NPV
of 0. If the cost stays the same or falls, the firm will replace the machine and get an NPV of $1.37
million or $4.37 million, respectively. Given the probabilities, the NPV of the five-year machine
over the 10-year horizon is
1
3 (0) + 13 (1.37) + 13 (4.37)
NPV5 yr, with uncertain replacement = 1.37 + = $2.56 million
1.105
Thus, given this uncertainty, the shorter-lived machine offers a higher NPV over 10 years
than the $2.43 million NPV of the longer-lived machine. By committing to the longer-
lived project, the firm would give up its real option to react to technological and market
changes.
Concept Check 1. Why is it inappropriate to simply pick the higher NPV project when comparing mutually exclusive
investment opportunities with different lives?
2. What is a major shortcoming of the equivalent annual benefit method?
22.6 Optimally Staging Investments

In analyzing the value of the option to grow, we considered the real option value of a
staged investment opportunity. The advantage of staging is that it allows us to postpone
investment until after we learn important new information. We can avoid making the
investment unless the new information suggests it is worthwhile.
In many applications, the stages have a natural order, for example, investing in a prototype
before developing on a large scale. But in some situations, we can choose the order of the
development stages. If so, how can we maximize the value of the real options that we create?
22.6â•‡ Optimally Staging Investments 845
An Example: Eclectic Motors.â•‡ Eclectic Motors is considering developing an electric car

that would compete directly with gasoline-powered cars. They must overcome three tech-
nological hurdles to produce a successful car:
1. Develop materials to significantly reduce the car’s body weight.
2. Develop a method to rapidly recharge the batteries.
3. Advance battery technology to reduce weight and increase storage capacity.
As shown in TableÂ€22.2, although Eclectic’s engineers have already made significant break-
throughs, further research and substantial risk remain for each task:
Suppose all three risks are idiosyncratic, and the risk-free interest rate is 6%. Given
Eclectic’s resources, the company can only work on one technology at a time. Eclectic’s
managers know that by appropriately staging these investments, they can enhance the
firm’s value. The question is, assuming that it makes sense to proceed, which technology
should they tackle first?
Mutually Dependent Investments.â•‡ Eclectic’s electric car project represents a situation
with mutually dependent investments, in which the value of one project depends upon
the outcome of the others. In this case, we assume that all three challenges must be over-
come, or there will be no benefit. Thus, we need to determine the optimal order of invest-
ment that will minimize the expected cost of development.
Investment Scale.â•‡ Consider first the materials and recharger technologies. These two are
identical except for the upfront investment costs. Let’s compare the expected cost of com-
pleting them in different orders. If we begin with the materials technology, the expected
cost to complete both is
1
100 + 0.50 * * 400 = $288.7 million
1.06
Investment Probability PV of Investment
in materials materials delay in recharger
technology
succeeds
If we begin with the recharger technology, the expected cost is

1
400 + 0.50 * * 100 = $447.2 million
1.06
in recharger recharger delay in materials
technology
succeeds
Table 22.2 equired Time, Cost, and Likelihood of Success

R
for Eclectic’s Project
Technology Cost Time Probability of Success
Materials $100 million 1 year 50%
Recharger $400 million 1 year 50%
Battery $100 million 4 years 25%
Thus, it is clear that Eclectic should invest in the materials technology before working
on the recharger. Because the cost of the recharger is greater, we don’t want to waste our
investment in it if the materials technology fails. As this example shows, other things being
equal, it is beneficial to make the least costly investments first, delaying more expensive
investments until it is clear they are warranted.
Investment Time and Risk.â•‡ Next, let’s compare the materials and battery technologies.
These projects have the same cost, but the battery technology will take longer and has a
greater chance of failure. Considering only these two projects, if we begin with the materi-
als technology, the expected cost of completing both is
1
100 + 0.50 * * 100 = $147.2 million
1.06
in materials materials delay in battery
technology
succeeds
If we begin with the battery technology, the expected cost is

1
100 + 0.25 * * 100 = $119.80 million
1.064
in battery battery delay in materials
technology
succeeds
Thus, Eclectic should work on the battery technology before working on the materials.
Given its greater risk, we will learn more if the battery project succeeds regarding the
viability of the overall project. Due to its longer time requirement, we also benefit from the
time value of postponing the following investments further. In general, other things being
equal, it is beneficial to invest in riskier and lengthier projects first, delaying future invest-
ments until the greatest amount of information can be learned.
A General Rule.â•‡ As we have seen, the cost, time, and risk of each project will determine
the optimal order in which to invest. Intuitively, by making smaller, riskier investments
first, we gain the most additional information at the lowest cost. (Thus, the battery project
should definitely come before the recharger project.) In general, we can find the opti-
mal order to stage mutually dependent projects by ranking each, from highest to lowest,
according to its failure cost index:
1 - PV (success)
Failure Cost Index = (22.3)
PV (investment)
where PV(success) is the value at the start of the project of receiving $1 if the project suc-
ceeds (i.e., the present value of the risk-neutral probability of success) and PV(investment)
is the project’s required investment, again expressed as a present value at the project’s start.
The failure cost index orders investments so that we gain the most information at the low-
est cost upfront.
M22_BERK0160_04_GE_C22.indd 846 8/20/16 11:49 AM

22.7â•‡ Rules of Thumb 847
Example 22.3 Deciding the Order of Investment with Multiple Stages
Problem
Use the failure cost index to determine the optimal investment order for Eclectic’s electric car
project.
Solution
Evaluating the failure cost index for each stage, we have
Materials: [1 - (0.50/1.06)]/100 = 0.00528
Recharger: [1 - (0.50/1.06)]/400 = 0.00132
Battery: [1 - (0.25/1.064)]/100 = 0.00802
So, Eclectic should develop the batteries first, then the body materials, and finally the charger,
matching our earlier analysis.
Until now, we have ignored the decision about whether it is optimal to develop at all. In
evaluating the overall investment decision, the first step is to decide the optimal order of
investment in each stage. Once that order has been determined, we can calculate the over-
all NPV of the opportunity and reach a decision on whether to proceed.
Example 22.4 Deciding Whether to Invest in a Project with Multiple Stages
Problem
Eclectic’s managers estimate that with these technological breakthroughs, they can develop the
electric car, and the present value of all future profits will be $4 billion. Does the decision to
develop the car make sense?
Solution
Using the optimal order from Example 22.3, the NPV is
100 400 4000
NPV = - 100 - 0.25 4
- 0.25 * 0.5 5
+ 0.25 * 0.5 * 0.5 6
= $19.1 million
1.06 1.06 1.06
Thus, it is profitable to develop the electric car. However, this result crucially depends on the
optimal staging—the NPV would be negative if Eclectic chose any other order!
Concept Check 1. Why can staging investment decisions add value?

2. How can you decide the order of investment in a staged investment decision?
22.7 Rules of Thumb

One of the major drawbacks of using the concepts introduced in this chapter is that they
are difficult to implement. In practice, correctly modeling the sources of uncertainty and
appropriate dynamic decisions usually requires an extensive amount of time and financial
expertise. Furthermore, in most cases, the solutions are problem-specific, so the time and
expertise spent on one problem are not transferable to other problems. Consequently,
many firms resort to following rules of thumb.8 Here, we examine two commonly used
rules of thumb: the profitability index and hurdle rates.
The Profitability Index Rule

As we explained in SectionÂ€ 22.1, when an investment opportunity can be delayed, it is
optimal to invest only when the NPV of the investment project is sufficiently high. In
most applications, it is quite difficult to calculate precisely how high the NPV must be to
trigger investment. As a result, some firms use the following rule of thumb: Invest whenever
the profitability index exceeds a specified level.
Recall from ChapterÂ€7 that in the simple case of a project where the only resource is the
upfront investment, the profitability index is
NPV
Profitability Index =
Initial Investment
The profitability index rule directs you to invest whenever the profitability index exceeds
some predetermined number. When the investment cannot be delayed, the optimal rule is
to invest whenever the profitability index is greater than zero. When there is an option to
delay, a common rule of thumb is to invest only when the index exceeds a higher thresh-
old, such as one. Often, firms set high thresholds because the cost of investing at the wrong
time is usually asymmetric. It is often better to wait too long (use a profitability index
criterion that is too high) than to invest too soon (use a profitability index criterion that is
too low).
The Hurdle Rate Rule

The profitability index rule raises the bar on the NPV to take into account the option to
wait. Rather than invest when the NPV is zero, you wait until the NPV is a multiple of
the initial investment. Instead of raising the bar on the NPV, the hurdle rate rule raises
the discount rate. The hurdle rate rule uses a higher discount rate than the cost of capital
to compute the NPV, but then applies the regular NPV rule: Invest whenever the NPV
calculated using this higher discount rate is positive. This higher discount rate is known as the
hurdle rate because if the project can jump this hurdle—that is, have a positive NPV at
this higher discount rate—then it should be undertaken.
When the source of uncertainty that creates a motive to wait is interest rate uncertainty,
there is a natural way to approximate the optimal hurdle rate. In this case, the rule of thumb
is to multiply the cost of capital by the ratio of the callable annuity rate, which is the rate
on a risk-free annuity that can be repaid (or calledâ•›â†œ) at any time, to the risk-free rate:
Callable Annuity Rate

Hurdle Rate = Cost of Capital * (22.4)
Risk@Free Rate
We should then invest whenever the NPV of the project is positive using this hurdle rate
as the discount rate.
8
See Robert McDonald, “Real Options and Rules of Thumb in Capital Budgeting,” in M. Brennan and
L.Â€ Trigeorgis (eds.), Project Flexibility, Agency, and Competition (Oxford University Press, 2000), for a
detailed analysis of the performance of different rules of thumb.
22.7â•‡ Rules of Thumb 849
What is the intuition for this rule? Let’s assume you have a risk-free project that you can
delay. It currently has a positive NPV. You intend to borrow the initial investment but you
are unsure whether you should wait in the hope that interest rates will fall. If you take out a
regular loan and interest rates decrease, you will be stuck paying a higher rate. However, if
you take out a callable loan and interest rates fall, then you can refinance the loan and take
advantage of the lower rates. So, if the project has a positive NPV using the callable annu-
ity rate as the discount rate, you can have your cake and eat it too: You can immediately
get the benefits of the investment by undertaking it and still take advantage of a lower rate
if rates fall. Thus, it makes sense to invest immediately. The rule of thumb approximately
implements this decision rule.
How large is the difference between the hurdle rate and the cost of capital? Because
government-guaranteed mortgages are insured against default and repayable by the bor-
rower at any time, they are an example of a callable annuity (as the box on the next page
explains). Based on the difference between mortgage and risk-free rates, using a hurdle rate
20% higher than the firm’s cost of capital might be a reasonable adjustment to account for
the firm’s ability to wait until interest rates are sufficiently favorable to invest.
Example 22.5 Using the Hurdle Rate Rule for the Option to Delay
Problem
You can invest in a risk-free technology that requires an upfront payment of $1 million and will
provide a perpetual annual cash flow of $90,000. Suppose all interest rates will be either 10%
or 5% in one year and remain there forever. The risk-neutral probability that interest rates will
drop to 5% is 90%. The one-year risk-free interest rate is 8%, and today’s rate on a risk-free
perpetual bond is 5.4%. The rate on an equivalent perpetual bond that is repayable at any time
(the Â�callable annuity rate) is 9%.9 Should you invest in the technology today, or wait and see if
rates drop and then invest?
Solution
Because the investment is risk free, the cost of capital is the risk-free rate. Thus, Eq. 22.4 suggests
using a hurdle rate equal to the callable annuity rate of 9%. With that rate,
90,000
NPV = - 1,000,000 = 0
0.09
The hurdle rate rule implies that you are indifferent. Let’s see if this is correct. The actual cost of
capital is 5.4% (the rate offered on a risk-free perpetuity), so the investment opportunity clearly
has a positive NPV:
90,000
NPV = - 1,000,000 = $666,667
.054
9
To check that these rates make sense, note that a $1000 perpetual bond paying $54 per year would
be worth $54 + 54/.05 = $1134 if interest rates fall and $54 + 54/.10 = $594 if rates rise, for a (risk-
neutral) expected payoff of 0.9 * 1134 + 0.1 * 594 = $1080, and an expected return equal to the
one-year risk-free rate of 8%. Similarly, a $1000 callable bond with a coupon of $90 would be worth
$90 + 1000 = $1090 if rates fall and the bond is prepaid, and $90 + 90/.10 = $990 if rates rise, again
for a risk-neutral expected payoff of 0.9 * 1090 + 0.1 * 990 = $1080.
Let’s see what the NPV of waiting is. If we delay the investment, it makes sense to invest only
if rates drop to 5%, in which case
90,000
NPVrates go down = - 1,000,000 = $800,000
0.05
The present value today of the expected NPV using risk-neutral probabilities is therefore
800,000 * 0.90
= $666,667
1.08
The hurdle rate rule is correct: You really are indifferent between investing today and waiting.
In situations like Example 22.5, when the cash flows are constant and perpetual, and
the reason to wait derives solely from interest rate uncertainty, the rule of thumb is exact.10
However, when these conditions are not satisfied, the rule of thumb merely approximates
the correct decision.
While using a hurdle rate rule for deciding when to invest might be a cost-effective way
to make investment decisions, it is important to remember that this rule does not provide an
accurate measure of value. The value of making an investment is the NPV calculated using
the cost of capital as the discount rate, not the hurdle rate. Thus, while the rule of thumb pro-
vides the correct time to invest in Example 22.5, the actual value of undertaking the invest-
ment is $666,667—the NPV when the correct cost of capital is used as the discount rate.
Potentially, there could be an advantage to using the hurdle rate and profitability index
rules of thumb simultaneously. That is, the decision when to invest can be made by first com-
puting the NPV using the hurdle rate in Eq. 22.4 to account for interest rate uncertainty. The
profitability index can then be calculated using this NPV, with the firm accepting the project
only if the profitability index exceeds a threshold that accounts for cash flow uncertainty.
The Option to Repay a Mortgage
As most homeowners know, mortgage interest rates are the U.S. government cannot. Consequently, if interest rates
higher than comparable risk-free rates like the yield on the drop, a mortgage holder can refinance—that is, repay the
30-year U.S. Treasury bond. One reason mortgage rates are existing mortgage and take out a new mortgage at a lower
higher than Treasury rates is the risk that the homeowner rate. This option to refinance is valuable to the borrower but
will default. But, for high-quality borrowers, this risk has costly to the lender: If rates fall, the mortgage holder will
remained relatively small, even through the financial crisis. repay the mortgage and replace it with a new mortgage at a
Furthermore, in many cases, mortgage lenders are insured lower rate, whereas if rates rise, the bank is stuck with a loan
against default by government agencies. Yet, mortgage rates that is now below the market rate. Of course, banks under-
for the best borrowers still exceed even the rates on some stand they have written this option, and so demand a higher
corporate debt. rate on the loan than the rate they would if the mortgage did
Mortgage interest rates are higher than Treasury rates not have the repayment option. As a result, mortgage rates
because mortgages have a repayment option that Treasuries have tended to be at least 20% higher than long-term risk-
do not have: You can repay your mortgage at any time, while free interest rates.
10
See J. Berk, “A Simple Approach for Deciding When to Invest,” American Economic Review 89 (1999):
1319–1326.
MyFinanceLab 851
Concept Check 1. Explain the profitability index rule of thumb.

2. What is the hurdle rate rule, and what uncertainty does it reflect?
22.8 Key Insights from Real Options

Although a general rule for how to account for all real options does not exist, there are a
few simple principles that we have covered in this chapter. In closing, it is worth restating
these principles:
Out-of-the-Money Real Options Have Value.â•‡ Even if an investment opportunity cur-
rently has a negative NPV, it does not imply that the opportunity is worthless. So long as
there is a chance that the investment opportunity could have a positive NPV in the future,
the opportunity is worth something today.
In-the-Money Real Options Need Not Be Exercised Immediately.â•‡ You should not
necessarily take on an investment opportunity that has a positive NPV today. If you can
delay the investment opportunity, the option to delay might be worth more than the NPV
of undertaking the investment immediately. In this case, you should not undertake the
investment and instead delay it.
Waiting Is Valuable.â•‡ Value can be created by waiting for uncertainty to resolve because
once uncertainty is resolved, you can make better decisions with better information. Thus,
if there is no cost to waiting, investing early never makes sense. If there is a cost, always
weigh the benefits of waiting for resolution of uncertainty against the costs of waiting.
Delay Investment Expenses as Much as Possible.â•‡ Because waiting is valuable, you should
only incur investment expenses at the last possible moment. Committing capital before it
is absolutely necessary reduces value because it gives up the option to make a better deci-
sion once uncertainty has been resolved.
Create Value by Exploiting Real Options.â•‡ In an uncertain environment, real options
create value for the firm. To realize this value, the firm must continually re-evaluate its
investment opportunities and optimize its decision-making dynamically. It is important to
keep in mind that often as much value can be created by optimally delaying or abandoning
projects as by creating or growing them.
Combining these insights, we find that by staging investments, and using clear
Â�valuation-based methods to determine at each stage if the firm should abandon, defer, con-
tinue, or grow an investment opportunity, managers can substantially increase firm value.
22.1â•‡ Real Versus Financial Options

n A real option is an option where the underlying asset is physical rather than financial.
22.2â•‡ Decision Tree Analysis

n A decision tree is a graphical way to represent alternative decisions and potential outcomes in an
uncertain economy. It contains decision nodes and information nodes.
22.3â•‡The Option to Delay: Investment as a Call Option

n By waiting before committing to an investment, a firm can obtain more information about the
investment’s returns. By correctly choosing the time to invest, it can add value.
n When you have the option of deciding when to invest, it is usually optimal to invest only when
the NPV is substantially greater than zero.
n Given the option to wait, an investment that currently has a negative NPV can have a positive
value.
n The option to wait is most valuable when there is a great deal of uncertainty regarding what the
value of the investment will be in the future.
n In the real option context, the dividends correspond to any value from the investment that we
give up by waiting. Absent dividends, a call option should not be exercised early.
n The beta of the option to invest is a multiple of the beta of the underlying investment opportu-
nity, and varies with its value.
22.4â•‡Growth and Abandonment Options

n By undertaking a project, a firm often gets the opportunity to make investments that it would
not have otherwise. The opportunity to invest in projects in the future—that is, the firm’s
growth options—is worth something today.
n When firms find themselves involved in a project that is losing money, with little prospect of
turning things around in the future, they can exercise their abandonment option and walk away.
22.5â•‡Investments with Different Lives

n In choosing between investments with different lives, a firm must take into account its option
to replace or extend the shorter-lived project at the end of its original life.
n Managers sometimes use the equivalent annual benefit method to compare projects of different
lengths. It implicitly assumes that the projects can be replaced at their original terms. Using
the equivalent annual benefit method might produce different recommendations when future
uncertainty is taken into account.
22.6â•‡ Optimally Staging Investments

n When deciding the order of investment for a multi-stage investment decision, there is a benefit
to making smaller and riskier investments first in order to gain additional information at low
cost. If the projects are mutually dependent so that all projects must succeed for the firm to
Â�realize any benefit, the optimal order can be determined by ranking the projects according to
the failure cost index in Eq. 22.3.
22.7â•‡ Rules of Thumb

n The profitability index rule of thumb calls for investing whenever the profitability index exceeds
some predetermined number. It is a way of accounting for the option to wait when there is cash
flow uncertainty.
n The hurdle rate rule of thumb computes the NPV using the hurdle rate, a discount rate higher
than the cost of capital, and specifies that the investment should be undertaken only when the
NPV computed this way is positive. It is a way of accounting for the option to wait when there
is interest rate uncertainty.
22.8â•‡Key Insights from Real Options

n Out-of-the-money real options have value.
n In-the-money real options need not be exercised immediately.
n Waiting is valuable.
n Delay investment expenses as much as possible.
n Create value by exploiting real options.
Problems 853
Key Terms abandonment option p. 836 growth option p. 836

callable annuity rate p. 848 hurdle rate p. 848
decision node p. 827 hurdle rate rule p. 848
decision tree p. 826 information node p. 827
equivalent annual benefit (EAB) p. 843 mutually dependent investments p. 845
equivalent annual benefit method p. 843 profitability index rule p. 848
equivalent annual cost p. 843 real option p. 826
failure cost index p. 846 refinance p. 850
Further Many people believe that by not explicitly accounting for the real options described in this
Reading Â�chapter, managers make costly mistakes. For an in-depth discussion of this issue, see T. Copeland,
V. Â�Antikarov, and T. Texere, Real Options: A Practitioner’s Guide (W. W. Norton & Company, 2003).
For a discussion of how to adjust firm betas for capital budgeting purposes see A. Bernardo, B. Chow-
dhry, and A. Goyal, “Assessing Project Risk,” Journal of Applied Corporate Finance 24 (2012): 94–100.
These books cover the topics of this chapter in more detail and depth: M. Amran and N.Â€Â�Kulatilaka,
Real Options: Managing Strategic Investments in an Uncertain World (Harvard Business School Press,
1999); M. Brennan and L. Trigeorgis, eds., Flexibility, Natural Resources, and Strategic Options
(Oxford University Press, 1998); A. Dixit and R. Pindyck, Investment Under Uncertainty (Princeton
University Press, 1994); H. Smit and L. Trigeorgis, Strategic Investment, Real Options and Games
(Princeton University Press, 2004); and L. Trigeorgis, Real Options (MIT Press, 1996).
For a discussion of how well the rules of thumb covered in this chapter perform in practice, see
R.Â€ McDonald, “Real Options and Rules of Thumb in Capital Budgeting,” in M. Brennan and
L.Â€Trigeorgis (eds.), Project Flexibility, Agency, and Competition (Oxford University Press, 2000).
For more information on how real options affect the view academics and practitioners have of cor-
porate finance, see T. Luehrman, “Strategy as a Portfolio of Real Options,” Harvard Business Review
(September–October 1998): 89–99; S. Mason and R. Merton, “The Role of Contingent Claims
Analysis in Corporate Finance,” in E. Altman and M. Subrahmanyan (eds.), Recent Advances in
Corporate Finance (Richard D. Irwin, 1985); and A. Triantris and A. Borison, “Real Options: State
of the Practice,” Journal of Applied Corporate Finance 14(2) (2001): 8–24.
Problems All problems are available in . An asterisk (*) indicates problems with a higher level of
difficulty.
Decision Tree Analysis

1. Your company is planning on opening an office in Japan. Profits depend on how fast the econ-
omy in Japan recovers from its current recession. There is a 50% chance of recovery this year.
You are trying to decide whether to open the office now or in a year. Construct the decision tree
that shows the choices you have to open the office either today or one year from now.
2. You are trying to decide whether to make an investment of $500 million in a new technology
to produce Everlasting Gobstoppers. There is a 60% chance that the market for these candies
will produce profits of $100 million annually, a 20% chance the market will produce profits of
$50 million, and a 20% chance that there will be no profits. The size of the market will become
clear one year from now. Currently, the cost of capital of the project is 11% per year. There is a
20% chance that the cost of capital will drop to 9% in a year and stay at that level forever, and
an 80% chance that it will stay at 11% forever. Movements in the cost of capital are unrelated
to the size of the candy market. Construct the decision tree that shows the choices you have to
make the investment either today or one year from now.
3. Consider the United Studios example in Section 22.2. Suppose United has the rights to pro-
duce the first film, but has not yet purchased the sequel rights.
a. How much are the sequel rights worth to United?
b. Suppose United can purchase the sequel rights now for $30 million. Alternatively, United
can pay $10 million now for the option to buy the sequel rights for $30 million in the
future. Which should it choose?
4. Using the information in Problem 2, rework the problem assuming you find out the size of the
Everlasting Gobstopper market one year after you make the investment. That is, if you do not
make the investment, you do not find out the size of the market. Construct the decision tree
that shows the choices you have under these circumstances.
The Option to Delay: Investment as a Call Option

5. Describe the benefits and costs of delaying an investment opportunity.
6. You are a financial analyst at Global Conglomerate and are considering entering the shoe busi-
ness. You believe that you have a very narrow window for entering this market. Because of
Christmas demand, the time is right today and you believe that exactly a year from now would
also be a good opportunity. Other than these two windows, you do not think another oppor-
tunity will exist to break into this business. It will cost you $35.2 million to enter the market.
Because other shoe manufacturers exist and are public companies, you can construct a perfectly
comparable company. Hence, you have decided to use the Black-Scholes formula to decide
when and if you should enter the shoe business. Your analysis implies that the current value
of an operating shoe company is $40.4 million and it has a beta of 1.1. However, the flow of
customers is uncertain, so the value of the company is volatile-your analysis indicates that the
volatility is 25% per year. Twenty percent of the value of the company is attributable to the
value of the free cash flows (cash available to you to spend how you wish) expected in the first
year. If the one-year risk-free rate of interest is 4.1%:
a. Should Global enter this business and, if so, when?
b. How will the decision change if the current value of a shoe company is $35.6 million instead
of $40.4 million?
c. Plot the value of your investment opportunity as a function of the current value of a shoe
company.
d. Plot the beta of the investment opportunity as a function of the current value of a shoe
company.
7. It is the beginning of September and you have been offered the following deal to go heli-skiing. If
you pick the first week in January and pay for your vacation now, you can get a week of heli-skiing
for $1800. However, if you cannot ski because the helicopters cannot fly due to bad weather, there
is no snow, or you get sick, you do not get a refund. There is a 30% probability that you will not
be able to ski. If you wait until the last minute and go only if you know that the conditions are
perfect and you are well, the vacation will cost $5400. You estimate that the pleasure you get from
heli-skiing is worth $6500 per week to you (if you had to pay any more than that, you would
choose not to go). If your cost of capital is 13% per year, should you book ahead or wait?
8. A professor in the Computer Science department at United States Institute of Technology has
just patented a new search engine technology and would like to sell it to you, an interested
venture capitalist. The patent has a 17-year life. The technology will take a year to implement
(there are no cash flows in the first year) and has an upfront cost of $100 million. You believe
this technology will be able to capture 1.15% of the Internet search market, and currently this
market generates profits of $1 billion per year. Over the next five years, the risk-neutral prob-
ability that profits will grow at 10.1% per year is 20% and the risk-neutral probability that
profits will grow at 5.1% per year is 80%. This growth rate will become clear one year from
now (after the first year of growth). After five years, profits are expected to decline 2% annually.
No profits are expected after the patent runs out. Assume that all risk-free interest rates are
constant (regardless of the term) at 10.1% per year.
Problems 855
a. Calculate the NPV of undertaking the investment today.

b. Calculate the NPV of waiting a year to make the investment decision.
c. What is your optimal investment strategy?
9. Consider again the electric car dealership in SectionÂ€ 22.3. Suppose the current value of a
Â�dealership is $5.2 million and the first-year free cash flow is expected to be $520,000 rather
than $600,000. What is the beta of a corporation whose only asset is a one-year option to open
a dealership? What is the beta if the first year’s cash flows are expected to be $710,000, so a
working dealership is worth $7.1 million?
10. Under the same assumptions as in SectionÂ€22.3, suppose your corporation owns an operating
electric car dealership, together with one-year options to open five more.
a. What is the value and beta of your firm if the expected first-year free cash flow for all dealer-
ships is $580,000?
b. What is the value and beta of your firm if the expected first-year free cash flow for all dealer-
ships is $350,000?
c. In which case do your options have higher beta? In which case does your firm have higher
beta? Why?
*11. The management of Southern Express Corporation is considering investing 20% of all future
earnings in growth. The company has a single growth opportunity that it can take either now or
in one period. Although the managers do not know the return on investment with certainty, they
know it is equally likely to be either 12% or 15% per year. In one period, they will find out which
state will occur. Currently the firm pays out all earnings as a dividend of $12 million; if it does not
make the investment, dividends are expected to remain at this level forever. If Southern Express
undertakes the investment, the new dividend will reflect the realized return on investment and
will grow at the realized rate forever. Assuming the opportunity cost of capital is 13.1%, what is
the value of the company just before the current dividend is paid (the cum-dividend value)?
*12. What decision should you make in Problem 2 if the one-year cost of capital is 15.44% and the
profits last forever?
Growth and Abandonment Options

13. Your R&D division has just synthesized a material that will superconduct electricity at room
temperature; you have given the go ahead to try to produce this material commercially. It will
take five years to find out whether the material is commercially viable, and you estimate that
the probability of success is 25%. Development will cost $9.6 million per year, paid at the
beginning of each year. If development is successful and you decide to produce the material,
the factory will be built immediately. It will cost $1019 million to put in place and will gener-
ate profits of $87 million at the end of every year in perpetuity. Assume that the current five-Â�
year risk-free interest rate is 9.7% per year, and the yield on a perpetual risk-free bond will be
11.6%, 10.4%, 7.8%, or 4.5% in five years. Assume that the risk-neutral probability of each
possible rate is the same. What is the value today of this project?
*14. You are an analyst working for Goldman Sachs, and you are trying to value the growth poten-
tial of a large, established company, Big Industries. Big Industries has a thriving R&D division
that has consistently turned out successful products. You estimate that, on average, the R&D
division generates approximately two new product proposals every three years, so that there is a
61% chance that a project will be proposed every year. Typically, the investment opportunities
the R&D division produces require an initial investment of $10.1 million and yield profits of
$1.06 million per year that grow at one of three possible growth rates in perpetuity: 3.2%, 0%,
and - 3.2%. All three growth rates are equally likely for any given project. These opportunities
are always “take it or leave it” opportunities: If they are not undertaken immediately, they disap-
pear forever. Assume that the cost of capital will always remain at 11.6% per year. What is the
present value of all future growth opportunities Big Industries will produce?
*15. Repeat Problem 14, but this time assume that all the probabilities are risk-neutral probabilities,
which means the cost of capital is always the risk-free rate and risk-free rates are as follows: The
current interest rate for a risk-free perpetuity is 8%; in one year, there is a 64.375% chance that
all risk-free interest rates will be 10% and stay there forever, and a 35.625% chance that they
will be 6% and stay there forever. The current one-year risk-free rate is 7%.
16. You own a small networking startup. You have just received an offer to buy your firm from a
large, publicly traded firm, JCH Systems. Under the terms of the offer, you will receive 1 million
shares of JCH. JCH stock currently trades for $24.53 per share. You can sell the shares of JCH
that you will receive in the market at any time. But as part of the offer, JCH also agrees that at
the end of the next year, it will buy the shares back from you for $24.53 per share if you desire.
Suppose the current one-year risk-free rate is 5.75%, the volatility of JCH stock is 29.3%, and
JCH does not pay dividends.
a. Is this offer worth more than $24.53 million? Explain.
b. What is the value of the offer?
17. You own a wholesale plumbing supply store. The store currently generates revenues of $1 million
per year. Next year, revenues will either decrease by 9.6% or increase by 4.8%, with equal prob-
ability, and then stay at that level as long as you operate the store. You own the store outright. Other
costs run $880,000 per year. There are no costs to shutting down; in that case you can always sell
the store for $510,000. What is the business worth today if the cost of capital is fixed at 9.6%?
*18. You own a copper mine. The price of copper is currently $1.54 per pound. The mine produces
1 million pounds of copper per year and costs $2 million per year to operate. It has enough
Â�copper to operate for 100 years. Shutting the mine down would entail bringing the land up to
EPA standards and is expected to cost $4.92 million. Reopening the mine once it is shut down
would be an impossibility given current environmental standards. The price of copper has an
equal (and independent) probability of going up or down by 25% each year for the next two
years and then will stay at that level forever. Calculate the NPV of continuing to operate the mine
if the cost of capital is fixed at 15.2%. Is it optimal to abandon the mine or keep it operating?
19. An original silver dollar from the late eighteenth century consists of approximately 24 grams of
silver. At a price of $0.19 per gram ($6 per troy ounce), the silver content of the coin is worth
about $4.50. Assume that these coins are in plentiful supply and are not collector’s items, so
they have no numismatic value. If the current price of silver is $0.19 per gram, will the price of
the coin be greater than, less than, or equal to $4.50? Justify your answer.
*20. You own a piece of raw land in an up-and-coming area in Gotham City. The costs to construct
a building increase disproportionately with the size of the building. A building of q square feet
costs 0.1 * q 2 to build. After you construct a building on the lot, it will last forever but you are
committed to it: You cannot put another building on the lot. Buildings currently rent at $100 per
square foot per month. Rents in this area are expected to increase in five years. There is a 50%
chance that they will rise to $200 per square foot per month and stay there forever, and a 50%
chance that they will stay at $100 per square foot per month forever. The cost of capital is fixed at
12% per year.
a. Should you construct a building on the lot right away? If so, how large should the
building be?
b. If you choose to delay the decision, how large a building will you construct in each possible
state in five years?
Investments with Different Lives

21. What implicit assumption is made when managers use the equivalent annual benefit method to
decide between two projects with different lives that use the same resource?
22. You own a cab company and are evaluating two options to replace your fleet. Either you can
take out a five-year lease on the replacement cabs for $491 per month per cab, or you can pur-
chase the cabs outright for $31,000, in which case the cabs will last eight years. You must return
the cabs to the leasing company at the end of the lease. The leasing company is responsible for
all maintenance costs, but if you purchase the cabs, you will buy a maintenance contract that
M22_BERK0160_04_GE_C22.indd 856 8/20/16 11:49 AM

Problems 857
will cost $101 per month for the life of each cab. Each cab will generate revenues of $1076 per
month. Assume the cost of capital is fixed at 11.1%.
a. Calculate the NPV per cab of both possibilities: purchasing the cabs or leasing them.
b. Calculate the equivalent monthly benefit of both opportunities.
c. If you are leasing a cab, you have the opportunity to buy the used cab after five years.
Assume that in five years a five-year-old cab will cost either $10,300 or $15,800 with equal
likelihood, will have maintenance costs of $505 per month, and will last three more years.
Which option should you take?
Optimally Staging Investments

23. Genenco is developing a new drug that will slow the aging process. In order to succeed, two
breakthroughs are needed: one to increase the potency of the drug, and the second to eliminate
toxic side effects. Research to improve the drug’s potency is expected to require an upfront
investment of $10 million and take 2 years; the drug has a 5% chance of success. Reducing
the drug’s toxicity will require a $30 million upfront investment, take 4 years, and has a 20%
chance of success. If both efforts are successful, Genenco can sell the patent for the drug to a
major drug company for $2 billion. All risk is idiosyncratic, and the risk-free rate is 6%.
a. What is the NPV of launching both research efforts simultaneously?
b. What is the optimal order to stage the investments?
c. What is the NPV with the optimal staging?
24. Your engineers are developing a new product to launch next year that will require both software
and hardware innovations. The software team requests a budget of $6 million and forecasts an
80% chance of success. The hardware team requests a $11 million budget and forecasts a 53%
chance of success. Both teams will need 6 months to work on the product, and the risk-free
interest rate is 3% APR with semiannual compounding.
a. Which team should work on the project first?
b. Suppose that before anyone has worked on the project, the hardware team comes back and
revises their proposal, changing the estimated chance of success to 78% based on new infor-
mation. Will this affect your decision in (a)?
Rules of Thumb
25. Your firm is thinking of expanding. If you invest today, the expansion will generate $11 million
in FCF at the end of the year and will have a continuation value of either $145 million (if the
economy improves) or $50 million (if the economy does not improve). If you wait until next
year to invest, you will lose the opportunity to make $11 million in FCF, but you will know the
continuation value of the investment in the following year (that is, in a year from now, you will
know what the investment continuation value will be in the following year). Suppose the risk-
free rate is 4%, and the risk-neutral probability that the economy improves is 37%. Assume the
cost of expanding is the same this year or next year.
a. If the cost of expanding is $83 million, should you do so today, or wait until next year to
decide?
b. At what cost of expanding would there be no difference between expanding now and
waiting? To what profitability index does this correspond?
26. Assume that the project in Example 22.5 pays an annual cash flow of $100,000 (instead of
$90,000).
a. What is the NPV of investing today?
b. What is the NPV of waiting and investing tomorrow?
c. Verify that the hurdle rate rule of thumb gives the correct time to invest in this case.
27. Assume that the project in Example 22.5 pays an annual cash flow of $80,000 (instead of $90,000).
a. What is the NPV of investing today?
b. What is the NPV of waiting and investing tomorrow?
c. Verify that the hurdle rate rule of thumb gives the correct time to invest in this case.
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A01_GORD2302_01_SE_FM.indd 4 28/05/15 7:33 pm

Pa rt
Long-term
Financing 8
THE LAW Of OnE PRicE cOnnEcTiOn . How should a firm raise the funds chApter 23
it needs to undertake its investments? In the capital structure part of the text, we dis- raising equity
cussed the financial manager’s choice between the major categories of financing, debt, Capital
and equity. In this part of the book, we explain the mechanics of implementing these
decisions. Chapter 23 describes the process a company goes through when it raises
chApter 24
equity capital. In Chapter 24, we review firms’ use of debt markets to raise capital.
Chapter 25 introduces an alternative to long-term debt financing—Â�leasing. By pre-
Debt Financing
senting leasing as a financing alternative, we apply the Law of One Price to determine
that the benefits of leasing must derive from tax differences, incentive effects, or other chApter 25
market imperfections. Leasing
859

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PArT

Notat ion IN THIS CHAPTER, WE INTRODUCE THE FINANCIAL OPTION, A

20.1 Option Basics

Understanding Option Contracts

Interpreting Stock Option Quotations

Table 20.1 Option Quotes for Amazon.com Stock

AMZN 77.03 +1.40

Source: Chicago Board Options Exchange at www.cboe.com

Example 20.1 Purchasing Options

Options on Other Financial Securities

20.2 Option Payoffs at Expiration

Long Position in an Option Contract

If the stock price is greater

than the strike price ($20),

Example 20.2 Payoff of a Put Option at Maturity

Short Position in an Option Contract

Example 20.3 Payoff of a Short Position in a Put Option

Stock Price ($)

Profit on Expiration Date ($)

–15 Stock Price ($)

Profits for Holding an Option to Expiration

Example 20.4 Profit on Holding a Position in a Put Option until Expiration

–15 Stock Price ($)

Returns for Holding an Option to Expiration

Stock Price ($) Stock Price ($)

Stock Price ($)

Example 20.5 Strangle

Figure 20.7â•‡ Portfolio Insurance

Concept Check 1. What is a straddle?

20.3 Put-Call Parity

Example 20.6 Using Put-Call Parity

M20_BERK0160_04_GE_C20.indd 769 8/20/16 11:52 AM

Example 20.7 Using Options to Value Near-Term Dividends

Feb 2016 Dec 2018 Index Options

Concept Check 1. Explain put-call parity.

M20_BERK0160_04_GE_C20.indd 770 8/20/16 11:52 AM

20.4 Factors Affecting Option Prices

Strike Price and Stock Price

Arbitrage Bounds on Option Prices

Option Prices and the Exercise Date

Option Prices and Volatility

Example 20.8 Option Value and Volatility

Concept Check 1. What is the intrinsic value of an option?

20.5 Exercising Options Early

C=S-K + dis(K ) + P (20.5)

What about an American put option on a non-dividend-paying stock? Does it ever

P=K-S + C - dis(K ) (20.6)

Example 20.9 Early Exercise of a Put Option on a Non-Dividend-Paying Stock

Table 20.2 Alphabet Option Quotes

GOOGL (ALPHABET INC (A)) 667.35 10.36

Source: Chicago Board Options Exchange at www.cboe.com

P=K-S + C - dis(K ) + PV(Div) (20.8)

Example 20.10 Early Exercise of Options on a Dividend-Paying Stock

Source: Chicago Board Options Exchange at www.cboe.com

SPX 879.56 1.47

Source: Chicago Board Options Exchange at www.cboe.com

20.6 Options and Corporate Finance

Equity as a Call Option

Equity as a Call Option

SPX 879.56 1.47

GOOG (GOOGLE INC) 700.77 5.38

C = P + S - PV(K ) - PV(Div) (20.4)

GOOG 422.27 7.87

60 1.06 max (60 50, 0) 10

40 1.06 max (40 50, 0) 0

54 max (60 54, 0) 6

40 max (40 50, 0) 0

20 max (20 50, 0) 0

C = S + B = 40(0.3065) - 8.67 = $3.59

Cd - Sd 13.25 - 45( - 0.6633)

JBLU 5.03 0.11