Basic Financial Options - Assignment Example

CORPORATE FINANCE TABLE OF CONTENT PAGES All about Financial Management 03 What is an Option 04 Financial Option 06 Call Option 07 Put Option 08 Real Option 09 Investment Timing Options 10 Growth Options 11 Abandonment Option 11 Flexibility Option 12 Determinants of Option Values 12 Conclusion 15 References 15 ALL ABOUT FINANCIAL MANAGEMENT: Finance department plays a vital role in every organization and ensures that the organization has enough resources and liquidity to meet its legal obligations as well as facilitate its shareholders. The primary goal of the finance manager is to ensure that his company has adequate supply of capital and sufficient statutory reserves. The financial manager or the chief financial officer (CFO) is responsible for financing the enterprise and acts as an intermediary between the financial system’s institution and markets. Major financial decisions made by the managers of a business are either investment decisions or financing decisions (Bierman, 2008). In investment decisions, manager considers the amount invested in the assets of the business and the composition of that investment. Investment in assets are more beneficial because its produces cash flow for the entity that are needed to meet operating expenses, pay interest to lenders and taxes to government. One of the best investment decisions is to invest in options, as the finance managers routinely use, currency, commodity and interest rate options because according to them that a number of varieties of corporate investment and financing decisions have options embedded in them. To know how and why Options are beneficent in investment and financing decisions we will see different aspects of options in this study, but firstly we must have a good idea about the options, so in order to get the maximum let’s discuss briefly regarding the options. Understanding basic financial options helps to manage the value inherent in these real options which often mean the difference between a successful project and a failure. WHAT IS AN OPTION? An option is a contract that gives its holders the right to buy or sell an asset or security at some predetermined price within a specified period of time. One thing should be kept in mind that the options is a ‘right’ not the ‘obligation’ to force a transaction to occur at some future time on terms and conditions agreed to now (Hull, 2000). The two main concepts in options are ‘call options’ and ‘put options’ on which the whole study is based. Call option is an option which gives the right to the shareholder to buy an underlying asset at a fixed price whereas to sell a particular asset on a specified underlying price is referred to as put options. Let’s consider the main concept we discussed earlier and further elaborate it with an appropriate example. As we know that a transaction which occurs at some future time is based on diversified terms and conditions. Suppose, the buyer of a call options on shares obtains the right to buy shares in future from the seller, (the seller is also called a writer) of the call at a price determined now. At a future time, the buyer of the call can exercise the right to obtain the shares at the predetermined price, regardless of what is then the current market price of the shares. Synonymously, the buyer of a put option has the right to sell the shares in the future to the writer of the put at a predetermined price, regardless of what is then the share’s current market price. In 2004, Microsoft awarded more than 800 million options to its employees, a lump sum of 16,000 options per employee because its granted options to executives and employees are a “hybrid” form of compensation at some companies, especially small ones. Options may be substituted for cash wages. We can observe the importance of options from this that the employees are willing to takeover even lower cash salaries if they are being facilitated by the options. Employees know the importance of options, they know that options gives them immense profit when they get mature, as per some financial gurus options are the best extrinsic rewards which induces the employees to work hard and give their 100% pertinently within the premises of the organization rather the cash salaries. Options clearly have value at the time they are issued to the employees, and they transfer wealth from existing shareholders to employees to the extent that they do not reduce cash expenditures or increase employees efficiency and productivity sufficiently. Microsoft is not the only company which granted options to the employees; Bank of America, Citigroup, JP Morgan, IBM, Ford, Chase and Goldman Sachs are also among those companies who facilitate their employees by more than 100 million options. Options consist of a vesting period during which the option holder can’t exercise his options. It can be understood easily by the following example; suppose a company grants 1000 options to its employee with an exercise price of $50, an expiration of 10 years also pertains to a vesting time period of 3 years. An employee can’t exercise the options even if the price rises above $50 before 3 years due to the vesting requirement. After the passage of vesting period an option holder have the legal rights to exercise the option. The two main concepts in Option pricing are Financial Options and Real Options. Let’s discuss each one in detail. FINANCIAL OPTIONS: A contract which is granted to the shareholders that gives the legal right to the shareholder to buy or sell an asset, share or security at some predetermined price within a specified time is called a financial option (Lewis, 2004). We have discus earlier about the expiry period, though it can vary with the finance principles of that particular country. American options principles have some contradiction with the European principles because American option has the quality to be exercised any time before expiration while on the contrary, European option can only be exercised on its expiration date. Elaborating this fact with a practical example would be good idea to understand, let suppose you owned 100 shares of General Electric (G.E) which on Friday, January 2004, sold for 53.50 per share. You could sell to someone the right to buy your 100 shares at any time until May 14, 2004 (expiration date) at a price of $55 per share. This concept pertains to the American options because the options can be exercised before the expiration period. By contrast, European option comes in place when the option exercised on the expiration date let say on, May 14, 2004. Such options exist and are traded on a number of exchanges. Chicago Board Option Exchange (CBOE) is the oldest and the largest exchange which deals in the trading of financial options. Financial Options trading is one of the hottest activities in United States. Leverage made options are easy for speculation with just a few dollars to make a fortune almost overnight. Call and put options are the two main types of financial options. Let’s discuss both of them in detail with practical examples and diagrams. CALL OPTIONS: An option which gives the right to option holder to buy an underlying asset or security at a fixed price is called a call option. Suppose Jermaine sells Peter a call option on the insurance company Allianz, having an $85 strike price and maturity period of 10 months. For 10 months (USA style) or after 10 months (European Style), Peter will have the right to buy one Allianz share at a price of $85, regardless of Allianz’s share at that moment. Peter is not required to buy a share of Allianz from jermaine but, if Allianz wants to, jermaine must sell him one for $85. Obviously, Peter will exercise his option only if Allianz’s share price is above $85. Otherwise, if Peter wants to buy an Allianz share then he will but on the market price less than $85. This is also called the mature options. The mature option diagram can be presented in this manner. At maturity, if Allianz is trading at $90, Peter will exercise his option, buy his Allianz shares at $85 and sell it again, if he wishes and make $5 in profit (minus the premium he paid for the options). PUT OPTION: Put option is an option which gives the right to the option holder to sell an underlying asset or security at a fixed price. Put options are legally, speaking, a promise to buy, made by the seller of the put option to the buyer of the put options. An option does not grant the same rights or obligations to each side. The buyer of any option has the right but not the obligations, whereas the seller of any option is obliged to follow through if the buyer requests. The diagram of put options is as below. The diagram highlights the asymmetry of risk involved: the buyer of the options risks only the premium, while his profit is almost unlimited, while the seller’s gain is limited, but his loss is potentially unlimited. Option would not exist or be taken into consideration if the future were known with certainty. In a risky environment, options remunerate the risk of an uncertain future. Companies like the fact that an option grant requires immediate cash expenditure, although it might dilute shareholders wealth if it is later exercised. REAL OPTIONS: Alternative or choices which become available with a business investment opportunity are called real options. This kind of option is referred to as a derivative instrument. More precisely we can say that it’s an option which grants right to the holder to buy or sell an underlying asset at a fixed price. According to basics of capital budgeting theory, a project’s net present value (NPV) is the present value of its expected future cash flows, which are discounted at a rate that reflects the riskiness of the expected future cash flows (FCF) (Schwartz, 2001). Management must abrogate the project proposal if the NPV of that particular project comes negative. The first step in valuing projects that have embedded options is to identify options. Several types of real options are often present, and managers especially the finance managers should always look for them. Even the more important thing is that the managers should try to create options within projects. Some types of real options are mentioned below. INVESTMENT TIMING OPTIONS: Conventional Net Present Value (NPV) analysis merely assumes that project will either be accepted or rejected, which implies that they will be taken into consideration now or never. In practice companies sometimes have a third choice like delay the decision until later, when more information is available. The option to delay is valuable when market demand is uncertain, but it is also valuable during periods of volatile interest rates. The propensity to wait can allow the firms to delay raising capital for projects until and unless the interest rates gets condense. GROWTH OPTIONS: An option which permits a company to increase its capacity if market conditions are better than expected is called growth options. A company can increase the capacity of an existing product line in a number of ways. One way is called a “peaking unit”. Such units have high variable costs and are used to produce additional power only if demand and therefore prices are high. Second way of increasing capacity allows a company to expand into new geographic markets. Obviously penetrating in the new territory will expand the business or capacity of the organization which helps it to grow more pertinently than before. The third way for enhancing capacity is the opportunity to add new products, including complementary products and successive “generations” of the original product. ABANDONMENT OPTIONS: Standard Discounted Cash Flow (DCF) analysis assumes that the assets will be used over a specified economic life while evaluating potential projects. Many projects contain abandonment options, while some projects must be operated over their full economic life, even though market conditions might mitigate and urge the cash flow to be lower than the expected cash flow. FLEXIBILITY OPTIONS: Many projects offer a flexibility option that permits the firm to alter operations depending on how conditions change during the life of the project. It is pertinent to include the examples of BMW’s Spartanburg, South California and auto assembly plant providers here. BMW needed the plant to produce sports coupes. If it would have built the plant configured to produce only these vehicles, the construction cost would be minimized. Therefore, BMW decided to spend additional funds to construct a more flexible plant. DETERMINANTS OF OPTION VALUES: Mentioned below are some of the determinants which may affect the value of an option. Level of Strike Price: The higher the strike price, the lower the call option price. Continuously changing strike price will compel the value of options to increase or condense eventually. Length of Options: The longer the option period, the higher the option price. This occurs because the longer the time before expiration, the greater the chance that the stock price will climb substantially above the exercise price. More precisely we can say that option price increases as the expiration date is lengthened. Market Price: The higher the stock’s market price in relation to the strike price, the higher will be the call option price. Diversified factors are there which induce the market price of the share to fluctuate like financial stability, investments in the country and prevailing situation in the country. Value of Underlying Assets: Fluctuation can be seen if fluctuation observed is in the value of underlying assets which consequently changes the value of underlying assets. An increase in the value of assets ultimately increases the value of calls and vice versa. Dividends Paid on Underlying Assets: If dividends payments are made on an asset during the life of the option, which are often made on yearly basis in order to facilitate the shareholders then the value of underlying assets can likely be decreased. Current stock price: If the current stock price increases, let say from $20 to $25, then the option value increases. Thus the value of the option increases as the stock price increases. Exercise Price: Let’s take the same above mentioned example and suppose that the price of the stock increases from $20 to $25, then the value of the option declines. Again, the decrease in the option value is less than the exercise price increase. Option Period: Time of expiration will influence the option value to increase or decrease. The value of the option depends on the chances for an increase in the price of the underlying stock, and the longer the option has to go, the higher the stock price may climb. Thus, a six month option is worth more than a three month option. Risk Free Rate (RFR): Risk free rate affects the value of the option to increase and vice versa. The risk free rate also plays a role in determining the values of the normal distribution function, but this effect is of secondary importance. Indeed, option prices in general are nor very sensitive to interest rate changes. Interest Rate: Increase or decrease in the interest rate is one of the determinants which effects the values to abate or hike increasingly interest rate will increase the value of calls while it intervenes in the hiking of put options with regards in increasing in interest rates. CONCLUSION: More precisely we can say that an option is a contract that gives its holders the right to buy or sell an asset, share or security at some predetermined price within a specific period of time. There are a number of determinants which affects the value of options. The valuations of financial and real options are dependent on their determinants which stress the value to fluctuate with respect to the fluctuation in the value of the determinants. REFERENCES Biger, N, & Hull, J. The Valuation Of Currency Options. London: British Library, 1983. Bierman, H. Accounting Finance Lesson of Enron. USA: Cornell University, 2008. Chance & Don M. An introduction to Derivatives and Risk Management. South –Western Collage Publishers, 2001. Hull & John C. Options, Futures and Other Derivatives. Prentice Hall, 2000. Lewis, R & Pendrill, D. Advance Financial Accounting. Edition: 7, London: British Library, 2004. Schwartz, E & Lenos. Real Options and Investment under Uncertainty. Cambridge : MIT Press, 2001 Read More