Chapter 20

Options and Corporate Finance

Learning Objectives

1. Define a call option and a put option, and describe the payoff function for each of these

options.

2. List and describe the factors that affect the value of an option

3. Name some of the real options that occur in business and explain why traditional NPV

analysis does not accurately incorporate their values.

4. Describe how the agency costs of debt and equity are related to options.

5. Explain how options can be used to manage a firms exposure to risk.

I. Chapter Outline

20.1 Financial Options

A financial option is a derivative security in that its value is derived from the value of

another asset.

The owner of a financial option has the right, but not the obligation, to buy or sell an

asset on or before a specified date for a specified price.

The asset that the owner has a right to buy or sell is known as the underlying asset.

The last date on which an option can be exercised is called the exercise date or

expiration date, and the price at which the option holder can buy or sell the asset is

called the exercise price or strike price.

A. Call Options

A call option gives the owner the right to buy, or call, the underlying asset.

Once the asset price goes above the exercise price, the value of the call option at

exercise increases dollar for dollar with the price of the underlying asset.

The buyer pays the seller a fee to purchase the option.

This fee, which is known as the call premium, makes the total return to the seller

positive when the price of the underlying asset is near or below the exercise price.

B. Put Options

The owner of a put option has the right to sell the underlying asset at a

prespecified price.

The payoff function for the owner of a put option is similar to that for a call

option, but it is the reverse in the sense that the owner of a put option profits if the

price of the underlying asset is below the exercise price.

The owner of a put option will not want to exercise that option if the price

of the underlying asset is above the exercise price.

When the value of the underlying asset is below the exercise price,

however, the owner of the put option will find it profitable to exercise the

option.

The payoff for the seller of the put option is negative when the price of the

underlying asset is below the exercise price.

The seller of a put option hopes to profit from the fee, or put premium, that he or

she receives from the buyer of the put option.

C. American, European, and Bermudan Options

 Options that can only be exercised on the expiration date are known as European

options.

American options can be exercised at any point in time on or before the expiration

date.

Bermudan options can be exercised only on specific dates during the life of the

option.

D. More on the Shapes of Option Payoff Functions

The payoff functions for options are not straight lines for all possible values of the

underlying asset.

Each payoff function has a kink at the exercise price, which exists

because the owner of the option has a right, but not the obligation, to buy

or sell the underlying asset. If it is not in the owners interest to exercise

the option, he or she can simply let it expire.

20.2 Option Valuation

It is more complicated to determine the value of an option at a point in time before the

expiration date because we dont know exactly how the value of the underlying asset will

change over time, and therefore we dont know if it will make sense to exercise the

option.

A. Limits on Option Values

We know that the value of a call option can never be less than zero, since the

owner of the option can always decide not to exercise it if doing so is not

beneficial.
 The value of a call option can never be greater than the value of the underlying

asset because it would not make sense to pay more for the right to buy an asset

than you would pay for the asset itself.

The value of a call option prior to expiration will never be less than the value of

that option at expiration because there is always a possibility that the value of the

underlying asset will be greater than it is today at some time before the option

expires.

When we consider the value of a call option at some time prior to expiration, we

must compare the current value of the underlying asset with the present value of

the exercise price, discounted at the risk-free rate.

The present value of the exercise price is the amount that an investor

would have to invest in risk-free securities at any point prior to the

expiration date to ensure that he or she would have enough money to

exercise the option when it expired.

B. Variables That Affect Option Values

The higher the current value of the underlying asset, the more likely it is that

the value of the asset will be above the exercise price when the call option

expires.

The higher the current value of the asset, the greater the likely

difference between the value of the asset and the exercise price when

the option expires.

 This means that, holding the exercise price constant, investors will pay

more for a call option if the underlying asset value is higher, because

the expected value of the option at expiration is higher.

The opposite relation applies to the exercise price in that the lower the

exercise price, the more likely that the value of the underlying asset will be

higher than the exercise price when the option expires.

The greater the volatility of the underlying asset value, the higher the value of

a call option on the asset prior to valuation.

The intuition here is that the value of an option will increase more

when the value of the underlying asset goes up than it will decrease

when the value of the underlying asset goes down. This means that a

greater potential change in the underlying price will be more beneficial

to the value of the option.

The greater the time to maturity, the more the value of the underlying asset is

likely to change by the time the option expires; this increases the value of an

option.

The time until the expiration affects the value of a call option through

its effect on the volatility of the value of the underlying asset.

The value of a call option increases with the risk-free rate.

Exercising a call option involves paying cash in the future for the

underlying asset.
 The higher the interest rate, the lower the present value of the amount

that the owner of a call option will have to pay to exercise it, which

translates into value for the owner of the option.

C. The Binomial Pricing Model

This simple model assumes that the underlying asset will have one of only

two possible values when the option expires.

The value of the underlying asset will either increase to some value

above the exercise price or decrease to some value below the exercise

price.

To solve for the value of the call option using this model, we must assume that

investors have no arbitrage opportunities with regard to this option.

Arbitrage is the act of buying and selling assets in a way that yields a

return above that suggested by the Security Market Line (SML).

To value the call option in our simple model, we will first create a portfolio

that consists of the asset underlying the call option and a risk-free loan.

The relative investments in these two assets will be selected so that the

combination of the asset and the loan has the same cash flows as the

call option when it expires, regardless of whether the value of the

underlying asset goes up or down.

This is called a replicating portfolio, since it replicates the cash flows

of the option.

The replicating portfolio will consist of:

x shares of the underlying stock, and

 a risk-free loan with a face value of y.

The value of the call option can be calculated.

Solve for the values of x and y.

Multiply the current cost of the underlying stock by x.

Subtract y from the above amount to yield the value of the call

option.

D. Put-Call Parity

Although there are other methods, the value of a put option can be calculated by the

relationship of a put to a call option with the same maturity and exercise price.

This relation is called put-call parity.

The formula for put-call parity is:

P = C + Xert V, where

P is the value of the put option,

C is the value of the call option,

X is the exercise price,

V is the current value of the underlying asset, and

e is the exponential function.

20.3 Real Options

Real options are options on real assets.

NPV analysis does not adequately reflect the value of real options, and while it might not

always be possible to directly estimate the value of the real options associated with a

project, it is important to recognize that they exist when we perform a project analysis.
A. Options to Defer Investment

An example is as stated in the text concerning the Russian government and an oil

field development project. In the example, the Russian government waited to see

what happened to the price of oil before deciding to exercise its option to acquire

an ownership interest in the Sakhalin II project.

The underlying asset in this option is the stream of cash flows that the

developed oil field would produce, while the exercise price is the amount

of money that the company would have to spend to develop it (drill the

well and build any necessary infrastructure).

The value of an option to defer investment is not reflected in an NPV analysis, for

NPV analysis does not allow for the possibility of deferring an investment

decision.

B. Options to Make Follow-On Investments

Some projects open the door to future business opportunities that would not

otherwise be available. This type of real option is an option to make follow-on

investments.

Options to make follow-on investments are inherently difficult to value because,

at the time we are evaluating the original project, it may not be obvious what the

follow-on projects will be.

Even if we know what the projects will be, we are unlikely to have enough

information to estimate what they are worth.

 Projects that lead to investment opportunities that are consistent with a

companys overall strategy are more valuable than otherwise similar

projects that do not.

C. Options to Change Operations

Options to change operations are related to the flexibility that managers have once

an investment decision has been made. These include the option to change

operations and to abandon a project. These options affect the NPV of a project

and must be taken into account at the time the investment decision is made.

The changes that managers might make can involve something as simple

as reducing output if prices decline or increasing output if prices increase.

D. Options to Abandon Projects

An option to abandon a project is the ability to choose to terminate a project by

shutting it down.

Management will save money that would otherwise be lost if the project

kept going. The amount saved represents the gain from exercising this

option.

E. Concluding Comments on NPV Analysis and Real Options

In order to use NPV analysis to value such an option, we would not only have to

estimate all the cash flows associated with the expansion but would also have to

estimate the probability that we would actually undertake the expansion and

determine the appropriate rate at which to discount the value of the expansion

back to the present.

20.4 Agency Costs

Agency conflicts between stockholders and debt holders and between stockholders and

managers arise because the interests of stockholders, lenders (creditors), and managers

are not perfectly aligned.

One reason is that the claims that they have against the cash flows produced by the firm

have payoff functions that look like different types of options.

A. Agency Costs of Debt

The payoff functions for stockholders and lenders (creditors) differ, as do the

payoff functions for different options.

The payoff function for the stockholders looks exactly like that for the owner of a

call option, where the exercise price is the amount owed on the loan and the

underlying asset is the firm itself.

If the value of the firm exceeds the exercise price, the stockholders will

choose to exercise their option; if it does not exceed the exercise price,

they will let their option expire unexercised.

One way to think about the payoff function for the lenders is that when they lend

money to the firm, they are essentially selling a put option to the stockholders.

This option gives the stockholders the right to put the assets to the

lenders for an exercise price that equals the amount they owe.

When the value of the firm is less than the exercise price, the stockholders

will exercise their option by defaulting.

The Dividend Payout Problem: The incentives that stockholders of a leveraged

firm have to pay themselves dividends arise because of their option to default.
 If a company faces some realistic risk of going bankrupt, the stockholders

might decide that they are better off taking money out of the firm by

paying themselves dividends.

This situation can arise because the stockholders know that the bankruptcy

laws limit their possible losses.

The Asset Substitution Problem: When bankruptcy is possible, stockholders

have an incentive to invest in very risky projects, some of which might even have

negative NPVs.

Stockholders have this incentive because they receive all of the benefits if

things turn out well but do not bear all of the costs if things turn out

poorly.

The Underinvestment Problem: Stockholders have incentives to turn down

positive-NPV projects when all of the benefits are likely to go to the lenders. The

problem arises from the differences in the payoff functions.

B. Agency Costs of Equity

Managers are hired to manage the firm on behalf of the stockholders, but

managers do not always act in the stockholders best interest.

The payoff function for a manager can be quite different from that for

stockholders. In fact, it can look a lot like that for a lender.

If a company gets into financial difficulty and a manager is viewed as

responsible, that manager could lose his or her job and find it difficult to

obtain a similar job at another company.

 o The most obvious way for a company to get into financial

difficulty is to default on its debt.

o Thus, as long as a company is able to avoid defaulting on its debt,

a manager has a reasonable chance of retaining his or her job.

The fact that the payoff function for a manager resembles that for a lender means

that managers, like lenders, have incentives to invest in less risky assets and to

distribute less value through dividends and stock repurchases than the

stockholders would like.

20.5 Options and Risk Management

Risk management typically involves hedging or reducing the financial risks faced by a

firm.

Options, along with other derivative instruments, such as forwards, futures, and swaps,

are commonly used to reduce risks associated with commodity prices, interest rates,

foreign exchange rates, and equity prices.

One interesting benefit of using options in this way is that they provide downside

protection but do not limit the upside.

This is just like buying insurance.

o Many insurance contracts are little more than specialized put options.

Options and other derivative instruments can be used to manage commodity price risks,

large swings in interest rates, risks associated with foreign exchange rates, as well as to

manage risks associated with equity prices as occurs within defined benefit pension

plans.
II. Suggested and Alternative Approaches to the Material

Chapter 20 considers the description, valuation, and use of options. The discussion begins with

financial options and how they are valued in a simple model. The chapter then turns to options on

real assets, known as real options. Real options often arise in corporate investment decisions,

such as the right to delay investing in a project, expanding a project, abandoning a project, or

making a change in the technology employed in a project. This framework provides a valuation

tool that is not properly reflected in an NPV analysis.

The chapter then revisits the agency costs of debt discussed earlier in Chapter 16. The

option-like payoffs that are embedded in the payoff to equity investors contribute to the problems

of asset substitution, underinvestment, dividend payout, and claim dilution. The discussion then

follows with how option-like payoffs contribute to conflicts between stockholders and the

managers. The chapter concludes with a discussion of the ways in which managers use financial

options to alter their companies exposures to various types of risks.

This material is generally considered advanced for a first course in finance, but the

subject matter is presented through a simple real-world discussion and the concepts are easy for

students to grasp. It is a chapter that students generally find interesting, given the frequent

appearance of derivatives in the popular press.

III. Summary of Learning Objectives

1. Define a call option and a put option, and describe the payoff function for each of

these options.

An option is the right, but not the obligation, to buy or sell an asset for a given price on or

before a given date. The price is called the exercise or strike price, and the date is called

the exercise date or expiration date of the option. The right to buy the asset is known as a

call option. The payoff from a call option equals $0 if the value of the underlying asset is

less than the exercise price at expiration. If the value of the underlying asset is higher than

the exercise price at expiration, then the payoff from the call option is equal to the value

of the asset value minus the exercise price. The right to sell the asset is called a put

option. The payoff from a put option is $0 if the value of the underlying asset is greater

than the exercise price at expiration. If the value is lower than the exercise price, then the

payoff from a put option equals the exercise price minus the value of the underlying asset.

2. List and describe the factors that affect the value of an option.

The value of an option is affected by five factors: the current price of the underlying

asset, the volatility of the value of the underlying asset, the time left until the expiration

of the option, the exercise price of the option, and the risk-free rate.

3. Name some of the real options that occur in business, and explain why traditional

NPV analysis does not accurately incorporate their value.

 Real options that are associated with investments include options to defer investment,

make follow-on investments, change operations, and abandon projects. Traditional NPV

analysis is designed to make a decision to accept or reject a project at a particular point in

time. It is not intended to incorporate potential value associated with deferring the

investment decision. Incorporating the value of the other options into an NPV framework

is technically possible but would be very difficult to do because the rate used to discount

the cash flows would change over time with their riskiness. In addition, the information

necessary to value real options using the NPV approach is not always available.

4. Describe how the agency costs of debt and equity are related to options.

There are two principal classes of agency conflicts. The first is between stockholders and

lenders. When there is a risk of bankruptcy, stockholders may have incentives to increase

the volatility of the firms assets, turn down positive-NPV projects, or pay out assets in

the form of dividends. Stockholders have these incentives because their payoff functions

look like those for the owners of a call option.

The other principal class of agency conflict is between managers and owners.

Managers tend to prefer less risk than stockholders and prefer to distribute fewer assets in

the form of dividends because their payoff functions are more like those of lenders than

those of stockholders. These preferences are magnified by the fact that managers are risk-

averse individuals whose portfolios are not well diversified.

5. Explain how options can be used to manage a firms exposure to risk.

A company can adjust its exposure to risks associated with commodity prices, interest

rates, foreign exchange rates, and equity prices by buying or selling options. For

example, a company that is concerned about the prices it will receive for products that

will be delivered in the future can purchase put options to partially or totally eliminate

that risk.
IV. Summary of Key Equations

Equation Description Formula

20.1 Put-call parity P = C + Xe-rt V

V. Before You Go On Questions and Answers

Section 20.1

1. What is a call option, and what do the payoff functions for the owner and seller of a call

option look like?

A call option gives the owner the right to buy or call the underlying asset at a

prespecified price. The payoff for the owner of a call option is zero when the value of the

underlying asset is below the exercise price, and increases dollar for dollar with the price

of the underlying asset once the asset price goes above the exercise price. The payoff for

the seller of a call option is 0 when the value of the underlying asset is below the exercise

price, and decreases dollar for dollar with the price of the underlying asset once the asset

price goes above the exercise price.

2. What is a put option, and what do the payoff functions for the owner and seller of a put

option look like?

A put option gives the owner the right to sell the underlying asset at a prespecified price.

The payoff for the owner of a put option is 0 when the value of the underlying asset is

above the exercise price, and increases dollar for dollar with decrease of the price of the

underlying asset when the asset price drops below the exercise price. The payoff for the

seller of a put option is 0 when the value of the underlying asset is above the exercise

price, and decreases dollar for dollar with decrease of the price of the underlying asset

once the asset price drops below the exercise price.

3. Why does the payoff function for an option have a kink in it?

The payoff function for an option has a kink at the exercise price. This kink exists

because the owner of the option has a right, not an obligation, to buy or sell the

underlying asset. If it is not in the owners interest to exercise the option, he or she can

simply let it expire.

Section 20.2

1. What are the limits on the value of a call option prior to its expiration date?

The value of a call option can never be less than zero since the owner of the option can

always decide not to exercise it if doing so is not beneficial. A second limit on the value

of a call option is that it can never be greater than the value of the underlying asset. It

would not make sense to pay more for the right to buy an asset than you would pay for

the asset itself. The third limit is that the value of a call option prior to expiration will

never be less than the value of that option at expiration. Because of the time value of

money, the final limit is that the value of a call option prior to expiration will never be

less than the difference between the current value of the underlying asset and the present

value of the exercise price.

2. What variables affect the value of a call option?

 The following five variables affect the value of a call option prior to expiration:

(1) Current value of the underlying asset

(2) Exercise price

(3) Volatility of the value of the underlying asset

(4) Time until the expiration of the option

(5) Risk-free rate of interest

3. Why are the variables that affect the value of a put option the same as those that affect

the value of a put option?

Given the value of a call option, the value of a put option can be calculated using the put-

call parity: P = C + Xe-rt V. We can see that the formula does not include any variables

other than the five factors in valuation of a call option.

Section 20.3

1. What is a real option?

Real options are options on real assets. In some cases, the value of real options can be

incorporated into an investment analysis by valuing the option separately using valuation

methods similar to those used to value financial options, and then adding this value to the

value estimated by traditional NPV analysis.

2. What are four different types of real options commonly found in business?

(1) Options to defer investment

(2) Options to make follow-on investments

(3) Options to change operations

(4) Options to abandon projects

3. Is it always possible to estimate the value of a real option? Why or why not?

In some instances, it is not possible to estimate the value of a real option because we do

not have enough information or because the necessary analysis is too complex. Although

it might not even be possible to directly estimate the value of the real options associated

with a project, it is important to recognize that they exist when you perform a project

analysis.

Section 20.4

1. What do the payoff functions for stockholders and lenders look like?

The payoff function for the stockholders looks exactly like that for the owner of a call

option where the exercise price is the amount owed on the loan and the underlying asset

is the firm itself. The payoff function for the lenders looks like that for the seller of a put

option, where the exercise price is the amount of the loan and the underlying asset is the

firm itself.
2. What does the payoff function for a typical manager look like?

When a company defaults on its debt, the payoff function for the manager will look

something like that for the lenderit will slope downward as the value of the firm

decreases. On the positive side, a managers payoff will increase with the value of the

firm when this value is above the amount that the company owes to its lenders.

Section 20.5

1. What is hedging?

Hedging is a method of reducing financial risks faced by a firm. Options, along with

other derivative instruments, such as forwards, futures, and swaps, are commonly used in

hedging.

2. What types of risks can options be used to manage?

Options can be used to manage risks associated with commodity prices, interest rates,

foreign exchange rates, and equity prices.

VI. Self-Study Problems

20.1 Of the two parties to an option contract, the buyer and the seller, who has a right and who

has an obligation?

Solution:

The buyer (owner) of the option has the right to exercise the option but is not required to

do so. The seller (or writer) of the option is obligated to take the other side of the

transaction if the option owner decides to exercise it.

20.2 The stock of Augusta Light and Power is currently selling at $12 per share. Over the next

year the company is undertaking a new electricity production project. If the project is

successful, the companys stock is expected to rise to $24 per share. If the project fails,

the stock is expected to fall to $8 per share. The risk-free rate is 6 percent. Calculate the

value today of a one-year call option on one share of Augusta Light and Power with an

exercise price of $20.

Solution:

First, determine the payoffs for the stock, a risk-free loan, and the call option under the

two possible outcomes. In one year, the stock price is expected to be either $8 or $24.

The loan will be worth $1.06 regardless of whether the project is successful. If the project

fails, the stock price will be less than the exercise price of the call option. The option will

not be exercised and will be worth $0. If the project is successful, the stock price will be
 higher than the exercise price of the call option. The option will be exercised; its value

would be the difference between the stock price and the exercise price, $4.

Stock (x) Risk-Free Loan (y) Call Option

Today $12 $1 ?

Expiration $8 $24 $1.06 $1.06 $0 $4

The stock and loan can be used to create a tracking portfolio, which has the same payoff

as the call option:

($8 x) + (1.06 y) = $0

$24 x) + (1.06 y) = $4

Solving the two equations yields: x = 0.25, y = -1.887

The value if the call option is the same as the current value of the portfolio:

($12 0.25) + ($1 -1.887) = $1.11

20.3 ADCPA International is a U.S.-based company that sells its products primarily in

overseas markets. The companys stock is currently trading at $50 per share. Depending

on the outcome of U.S. trade negotiations with the countries to which ADCAP exports its

products, the companys stock price is expected to be either $65 or $30 in six months.

The risk-free rate is 8 percent per year. What is the value of a put option on ADCAP

stock that has an exercise price of $40 per share?

Solution:
First determine the payoffs for the stock, a risk-free bond, and the put option under the

two possible outcomes.

To determine payoff of the bond six months from now, we must calculate the six-month

risk-free interest rate given the one-year risk-free rate listed in the problem statement.

Six-month risk-free rate = (1 +0.08)1/2 1 = 1.039, or 3.9%

The payoffs are therefore:

Stock (x) Risk-Free Loan (y) Put Option

Today $50 $1 ?

Expiration $30 $65 $1.039 $1.039 $10 $0

Now we can use the stock and bond to create a tracking portfolio, which will give the

same payoff as the put option:

($30 x) + (1.039 y) = $10

($65 x) + (1.039 y) = $0

Solving the two equations, we determine x = 0.286, y = 17.87

The value of the put option is the same as the current value of this portfolio:

($50 0.286) + ($1 17.87) = $3.58

Alternatively, you could solve this problem by calculating the value of a call option with

an exercise price of $40 per share and then using the put-call parity relation. The value of

the call option is $15.09, and the value of the associated put option calculated using the
 put-call parity relation is $3.52. The difference is due to rounding and the compounding

assumption for the discount rate.

20.4 Your company is considering opening a new factory in Europe to serve the growing

demand for your product there. What real options might you want to consider in your

capital budgeting analysis of the factory?

Solution:

At least two significant real options might be associated with the factory. First, the

existence of a factory in Europe, and of the employees and management associated with

it, may enable your company to introduce products to the European markets. Second, if

things go badly for your European presence, you may be able to sell the factory and

abandon the project.

20.5 Your firm, which uses oil as an input to its production processes, hedges its exposure to

changes in the price of oil by buying call options on oil at todays price. If the price of oil

goes down by the time the contract expires, what effect will that have on your company?

Solution:

The effect on your company of the decline in the price of oil will be to increase earnings.

This is because the oil is an input to your production process, and a drop in prices will

reduce your expenses. Since the price of oil went down, you would let the call option
 expire without exercising it. Of course, the benefit your company receives from the drop

in oil prices will be reduced by the amount that you paid to purchase the option.

.
VII. Critical Thinking Questions

20.1 Options can be combined to create more complicated payoff structures. Consider the

combination of one put option and one call option with the same expiration date and the

same strike price. Draw the payoff diagram and describe what the purchaser of such a

combination thinks will happen before expiration.

The payoff diagram will be in the shape of a V centered at the strike price:

Buy Put
Value
and
C
al
l

K Stock Price

This combination is called a straddle. Its purchaser thinks that the value of the underlying

asset will change significantly, but he is unsure in which direction it will move. If he is

correct, one of his options will expire worthless, but the other will be exercised (and have

value). If he is wrong, the payoff from the option that ends up being exercised will not be

enough to cover the expense of buying the options in the first place.
20.2 A writer of a call option may or may not actually own the underlying asset. If he or she

owns the asset, and therefore will have the asset available to deliver should the option be

exercised, he or she is said to by writing a covered call. Otherwise he or she is writing a

naked call and will have to buy the underlying asset on the open market should the option

be exercised. Draw the payoff diagram of a covered call (including the value of the

owned underlying asset) and compare it with the payoff of other options.

Value Covered Call

K
Stock Price

A covered call has the same payoff shape as a put option, but it is shifted upward by the

value of the strike price. This is equivalent to the combination of a put option and a risk-

free bond.

20.3 An American option will never be worth less than a European option. Evaluate this

statement.
 This statement is true. An American option has all the rights that a European option has.

In addition, it can be exercised on any date prior to the exercise date. Since these

additional rights can never have a negative value, an American option will always be

worth at least as much as a corresponding European option.

20.4 Explain why, in the binomial pricing theory, the probabilities of an up move versus a

down move are not important.

The replicating portfolio calculated to value the option in this model will have the same

value as the option whether the stock goes up or down. The probability of an up move

could be 99 percent or 1 percent, and that would not change. The replicating portfolio is

not determined by the likelihood of the two possibilitiesonly the option value in those

two cases. That said, the value of the replicating portfolio (and therefore the option) is

affected by the current stock price, which, presumably, would change with the

probabilities of up or down stock price moves.

20.5 Like all other models, the binomial pricing model is a simplification of reality. In this

model, how do we represent high volatility or low volatility of the value of the underlying

asset?

The difference between the high and low possible future prices represents volatility. If

these two numbers are relatively close together, that represents low volatility of the value
 of the underlying asset. The further apart they are, the higher the volatility the model

represents.

20.6 How do real options differ from financial options?

Real options arise from the operations of the company. They generally could not be

purchased separately, but they sometimes form an important part of the value of projects

available to the firm. They are options on underlying assets that are not publicly traded.

Financial options or traded options are available separately and frequently are

options on assets that are also publicly traded. As a result, their value is generally easier

to estimate (since we have the traded value of the underlying asset). We can also use

traded options to manage our risk exposure.

20.7 What kinds of real options should be considered in the following situations?

a. Wingnuts R Us is considering two sites for a new factory. One is just large enough for

the planned facility, while the other is three times larger.

b. Carousel Cruises is purchasing three new cruise ships to be built sequentially. The first

ship will commence construction today and will take one year to build. The second

will then be started. Carousel can cancel the order for a given cruise ship at any time

before construction begins.

Wingnuts R Us should consider the option to expand operations. Carousel should consider

the option to abandon their order and not take delivery of the additional ships.
20.8 Future Enterprises is considering a factory that will include an option to expand

operations in three years. If things go well, the anticipated expansion will have a value of

$10 million and will cost $2 million to undertake. If not, it will have a value of $1

million, and so it will not expand. What additional information would be needed in order

to analyze this capital budgeting problem using the traditional NPV approach that we

would not need using option valuation techniques?

In order to use traditional NPV techniques, we need to know the probability of things

going well so that we can estimate the expected cash flows. We will also need to know

how the performance of the overall economy affects these probabilities so that we can

estimate an appropriate discount rate for the expected expansion cash flows.

20.9 Corporations frequently include employee stock options as a part of the compensation for

their managers and sometimes for all their employees. These options allow the holder to

buy the stock of the company for a preset price like any other option, but they are usually

very long lived, with maturities of 10 years. The goal of stock option plans is to align the

incentives of employees and shareholders. What are the implications of these plans for

current shareholders?

Such plans have the effect of diluting the value of any gains in stock price. When the

value of the firm goes up, the options will be exercised and the result will be more people

with a claim on the same underlying assets. The value of each claim will be reduced. At
 the same time, the objective of the plans is to mitigate the agency problems associated

with managers and employees incentives. Managers and employees who have been

granted stock options have more to gain when the company does well. They are less

likely to be too conservative when deciding which projects the company will pursue. If

the stock option plans achieve their objective, the firm will be worth more than it would

have been without the plan, and so there will be more wealth to split up. Finding a good

trade-off between these effects is a challenge.

20.10 You are a bondholder of ABC Corp. Using option pricing theory, explain what agency

concerns you would have if ABC were in danger of bankruptcy.

The equity of a firm can be thought of as a call option on the assets of the firm. If the

firm is close to bankruptcy, you as a bondholder should be concerned that the company

will take actions to increase the volatility of the assets by investing in highly risky

projects, turn down positive-NPV projects, and, possibly, try to increase the dividend

payouts. All of these actions can increase the value of the equity at the expense of the

value of the debt holders.

20.11 A bond covenant is a part of a bond contract that restricts the behavior of the firm, barring

it from taking certain actions. Using the terminology of options, explain why a bond

contract might include a covenant preventing the firm from making large dividend

payments to its shareholders.

 Cash on hand reduces the total volatility of the value of the firm. If any cash on hand is

paid out to shareholders in the form of a large dividend payment, the volatility of the firm

will increase and the value of the debt will decrease. In order to prevent this, bonds often

feature covenants restricting the firm to dividend payments no larger than some fraction

of current earnings.

20.12 How can the insurance policy on a car be viewed as an option?

The insurance policy on a car can be viewed as a put option. In the extreme case, where

your car is totaled, you have the right to put the car to the insurance company for its

market value prior to the accident.

VIII. Questions and Problems

BASIC

20.1 Option characteristics: What is an option?

Solution:

An option is the right to buy or sell an asset at a prespecified price on or before a

prespecified date?

20.2 Option characteristics: Explain how the payoff functions differ for the owner (buyer)

and seller of a call option; of a put option.

Solution:

(1) Call option:

When the value of the underlying asset is below the exercise price, the payoffs for both

the buyer and seller of a call option are 0. Once the asset price goes above the exercise

price, the payoff for the buyer increases dollar for dollar with the price of the underlying

asset, while the payoff for the seller decreases dollar for dollar with the price of the

underlying asset. The sum of the payoffs of the buyer and seller of a call option is always

0.

(2) Put option:

 When the value of the underlying asset is above the exercise price, the payoffs for both

the buyer and seller of a put option are 0. Once the asset price drops below the exercise

price, the payoff for the buyer increases dollar for dollar with decrease of the price of the

underlying asset, while the payoff for the seller decreases dollar for dollar with decrease

of the price of the underlying asset. The sum of the payoffs of the buyer and seller of a

put option is always 0.

20.3 Option payoffs: What is the payoff to a call option with a strike price of $50 if the stock

price at expiration is $40? What if it is $65?

Solution:

If the stock price is $40, then the option will not be exercised and the option is worthless.

(Why buy for $50 what you can buy in the market for $40?) If the stock price is $65, then

the option is worth the difference between the price and the strike price: $65 $50 = $15.

20.4 Option payoffs: What is the payoff to a put option with a strike price of $50 if the stock

price at expiration is $40? What if it is $65?

Solution:

If the stock price is $40, then the option is worth the difference between the strike price

and the stock price: $50 40 = $10. If the stock price is $65, then the option is worthless.
20.5 Option valuation: What are the five variables that affect the value of an option, and how

do changes in each of these variables affect the value of a call option?

Solution:

The value of a call option increases as:

(1) Current value of the underlying asset increases;

(2) Exercise price decreases;

(3) Volatility of the value of the underlying asset increases;

(4) Time until the expiration of the option increases; or

(5) Risk-free rate of interest increases.

20.6 Option valuation: Assuming nothing else changes, what happens to the value of an

option as time passes and the expiration date gets closer?

Solution:

The value of an option declines as time passes.

20.7 Option valuation: What does the seller of a put option hope will happen?

Solution:

He hopes the option will not be exercised. In this case, the option will be exercised if the

asset value at expiration is lower than the strike price, so he hopes the asset value will rise

(or at least will remain above the strike price).

20.8 Option valuation: What is the value of a call option if the stock price is zero? What if

the stock price is extremely high (relative to the strike price)?

Solution:

If the stock price is zero, then there is no possibility that the stock will have positive

value. Thus the option to buy the stock in the future is worthless. If the stock price is

extremely high compared to the strike price, then there is essentially zero probability that

the stock price will be below the strike price at expiration. The option will always be

exercised, and the value of the option is the difference between the current stock price and

the present value of the strike price.

20.9 Option valuation: Like owners of stock, owners of options can lose no more than the

amount they invested. They are far more likely to lose that full amount, but they cannot

lose more. Do sellers of options have the same limitation on their losses?

Solution:

No. The seller of a call option can lose a theoretically unlimited amount of money

because the value of the underlying asset can go arbitrarily high. The seller of a put

option is limited to losing the amount of the strike price (since that is how much they

would lose if the stock price went to zero).

20.10 Option valuation: What is the value at expiration of a call option with a strike price of

$65 if the stock price is $1? $50? $65? $100? $1,000?

Solution:

The value of the option for any stock price less than $65 (including $1 and $50) is zero

because the option would not be exercised. When the stock price is equal to the strike

price ($65 in this case), the option owner does not care whether or not he exercises the

option. He gains (or loses) nothing. Again, the option is worth zero. If the stock price is

higher than the strike price, the option is worth the difference. If the stock is worth $100,

the option is worth $35. If the stock is worth $1,000, the option is worth $935.

20.11 Option valuation: Suppose you have an option to buy a share of ABC Corp stock for

$100. The option expires tomorrow, and the current price of ABC Corp is $95. How much

is your option worth?

Solution:

Your option is worth very slightly more than zero. There is little chance that the stock

price will move above $100 by tomorrow, but the chance is not zero, so the option still

has some value.

20.12 Option valuation: You hold an American option to sell one share of Zyther Co., which

expires tomorrow. The strike price of the option is $50, and the current stock price is $49.
 What is the value of exercising the option today? If you wanted to sell the option instead,

about how much would you expect to receive?

Solution:

The value of exercising today is the difference between the strike price and the stock

price: $1. If you sold the option, you should expect to receive slightly more than that.

20.13 Real options: What is the difference between a financial option and a real option?

Solution:

The underlying asset of a financial option is a financial asset, while the underlying asset

of a real option is associated with investment projects.

20.14 Real options: List and describe four different types of real options that are associated

with investment projects.

Solution:

Four types of real options are associated with investment projects:

(1) Options to defer investment: the ability to defer an investment decision until

information on its future cash flows is less uncertain.

(2) Options to make follow-on investments: the possibility to exploit future business

opportunities that will not otherwise be available if the investment is not taken.
 (3) Options to change operations: the flexibility in changing operations as business

conditions change if the investment is taken.

(4) Options to abandon projects: the ability to terminate the project at a smaller loss if

things do not go as well as anticipated.

20.15 Agency costs: How are options related to the agency costs of debt and equity?

Solution:

Agency costs arise since the incentives of shareholders are different from those of the

debt holders. Equity and debt claims are like different types of options on the firm. The

payoff function for the stockholders looks exactly like that for the owner of a call option

where the exercise price is the amount owed on the loan and the underlying asset is the

firm itself. The payoff function for the lenders looks like that for the seller of a put option,

where the exercise price is the amount of the loan and the underlying asset is the firm

itself. The different payoff functions create different incentives for shareholders and debt

holders. For example, shareholders are likely to pursue more risky projects. The increased

volatility of cash flows increases the expected payout for the holder of a call option, the

shareholder, and decreases the expected payout for the seller of a put option, the debt

holder.

INTERMEDIATE
20.16 Option valuation: Suppose that you own a call option and a put option on the same stock

and that these options have the same exercise price. Explain how the relative values of

these two options will change as the stock price increases or decreases.

Solution:

When stock prices increase, the value of the call option increases and the value of the put

option decreases; when stock prices decrease, the value of the call option decreases and

the value of the put option increases. The further the stock price is from the exercise

price, the more valuable the combination of these options becomes.

20.17 Other options: A callable bond is a bond that can be bought back by the bond issuer

before maturity for some prespecified price (normally face value) at the discretion of the

bondholder. How would you go about finding the value of such a bond? Would the bond

be worth more or less than an equivalent, noncallable bond?

Solution:

The purchaser of a callable bond is simultaneously selling the issuer a call option on that

bond. The value would be equal to the value of the straight bond minus the value of the

option. This is clearly less than the value of the (noncallable) bond by itself.

20.18 Other options: A convertible bond is a bond that can be exchanged for stock at the

discretion of the bondholder. How would you go about finding the value of such a bond?

Would the bond be worth more or less than an equivalent, nonconvertible bond?
 Solution:

A convertible bond is equivalent to a combination of a nonconvertible bond and a call

option on the stock, where the strike price of the option is the value of the bond. Because

the value of the bond may change along with the value of the stock, this is not a

straightforward problem, but the value would be equal to the value of the straight bond

plus the value of the option. This is clearly more than the value of the (nonconvertible)

bond by itself.

20.19 Option valuation: The seller of an option can never make any money from the change in

the value of the underlying asset. He or she can only hope that the option will not be

exercised and that no money will be lost. Given that this is the case, why do people write

options?

Solution:

Option writers receive the value of the option up front. The money the seller receives by

selling the bond is referred to as the bond premium. This payment compensates them for

the obligation they are taking on.

20.20 Option valuation: The stock of Socrates Motors is currently trading for $40 and will

either rise to $50 or fall to $35 in one month. The risk-free rate for one month is 1.5

percent. What is the value of a one-month call option with a strike price of $40?
 Solution:

Stock (X) Risk-Free (Y) Option

Today $40 $1 ???

Expiration
$35 $50 $1.015 $1.015 $0 $10

These two equations define our portfolio:

$10 = ($50 X) + ($1.015 Y)

$0 = ($35 X) + ($1.015 Y)

and the solution is X = 2/3 and Y = -$22.99. That is, we borrow $22.99 and buy two-

thirds of a share of Socrates Motors at a cost of $40.00 per share. The total net cost of this

portfolio is $40.00 (2/3) 22.99 = $3.68 and this is the value of the option.

20.21 Option valuation: Again assume that the price of Socrates Motors stock will either rise

to $50 or fall to $35 in one month and that the risk-free rate for one month is 1.5 percent.

How much is an option with a strike price of $40 worth if the current stock price is

instead $45?

Solution:

The replicating portfolio of X = 2/3 and Y = -$22.99 does not depend on the current stock

price and so would not change. The value of that portfolio would now be $45 (2/3)

$22.99 = $7.01, and this is the value of the option.

20.22 Option valuation: Assume that the stock of Socrates Motors is currently trading for $40

and will either rise to $50 or fall to $35 in one month. The risk-free rate for one month is

1.5 percent. What is the value of a one-month call option with a strike price of $25?

Solution:

Stock (X) Risk-Free (Y) Option

Today $40 $1 ???

Expiration
$35 $50 $1.015 $1.015 $10 $25

These two equations define our portfolio:

$25 = ($50 X) + ($1.015 Y)

$10 = ($35 X) + ($1.015 Y)

and the solution is X = 1 and Y = -$24.63. That is, we borrow $24.63 and buy 1 share of

Socrates Motors at a cost of $40. The total net cost of this portfolio is $40 $24.63 =

$15.37, and this is the value of the option.

20.23 Option valuation: You are considering a three-month put on Wing and A Prayer

Construction. The company currently trades for $10 per share and will either rise to $15

or fall to $7 in three months. The risk-free rate for three months is 2 percent. What is the

appropriate price for a put with a strike price or $9?

Solution:

If the stock rises to $15, then the option will not be exercised and its payoff will be $0. If

the stock falls to $7, the option will be exercised and its value will be the difference

between the strike price and the stock price, $2.

Stock (X) Risk-Free (Y) Option

Today $10 $1 ???

Expiration
$7 $15 $1.02 $1.02 $2 $0

The formulas that define the replicating portfolio are:

$2 = ($7 X) + ($1.02 Y)

$0 = ($15 X) + ($1.02 Y)

and the solution is X = -$0.25 and Y = $3.68. That is, we will short sell one-fourth of a

share of the stock, receiving $2.5, and we will lend $3.68 at the risk-free rate. (Short

selling is the process of borrowing an asset that you do not own and selling, with the
 promise that at some time in the future you will buy it back and return it to its owner.)

The net cost is $3.68 $2.50 = $1.18. This is the value of the option.

20.24 Option valuation: You hold a European put option on Tubes, Inc., with a strike price of

$100. Things havent been going too well for Tubes. The current stock price is $2, and

you think that it will either rise to $3 or fall to $1.5 at the expiration of your option. The

appropriate risk-free rate is 5 percent. What is the value of the option? If this were an

American option, would it be worth more?

Solution:

Note that this option will be exercised regardless.

Stock (X) Risk-Free (Y) Option

Today $2.0 $1 ???

Expiration
$1.5 $3.0 $1.05 $1.05 $98.5 $97

The formulas that define the replicating portfolio are:

$98.5 = ($1.5 X) + ($1.05 Y)

$97 = ($3 X) + ($1.05 Y)

and the solution is X = -1 and Y = $95.24. That is, we will short sell 1 of a share of the

stock, receiving $2, and we will lend $95.24 at the risk-free rate. The net cost is $95.24

$2.00 = $93.24. This is the value of the (European) option.

 If this were an American option, we could exercise today if we wanted. We would

want to do so if the value of exercising today was greater than the value of the option.

Exercising today would allow us to sell for $100 something worth $2, a gain of $98. This

is more than $93.24. The American option is worth more.

20.25 Other options: A golden parachute is a part of a managers compensation package that

makes a large lump-sum payment in the event that the manager is fired (or loses his or her

job in a merger, for example). This seems ill-advised to most people first hearing about it.

Explain how a golden parachute can help reduce agency costs between stockholders and

managers.

Solution:

Managers have incentives to avoid bankruptcy or even underperformance because the

personal cost to them is quite high. As a result they may choose to avoid high risk

investments even if those investments are highly positive NPV. The costs to the manager

if the project goes badly outweigh the benefits if it goes well. However, stockholders

want the manager to take positive-NPV projects, even if they are risky. Golden parachutes

help to solve this problem by reducing the costs to the manager associated with poor

performance or bankruptcy. The manager faces a payoff structure like the seller of an

option. Golden parachutes serve to reduce the volatility of that option and therefore to

reduce the value of that option.

ADVANCED
20.26 Consider the following payoff diagram.

Value

$10

Stock price
$40 $50 $60

Find a combination of calls, puts, risk-free bonds, and stock that has this payoff. (You

need not use all of these, and there are many possible solutions.)

Solution:

One possible solution would consist of four options:

(a) Buy a call with a strike of $50.

(b) Buy a put with a strike of $50.

(c) Sell a put with a strike of $40.

(s) Sell a call with a strike of $60.

If the stock price at expiration is below $40, then neither call will be exercised, but both

puts will be. We will be forced to buy the stock for $40 because of option c, but we will

be able to sell it for $50, using option b.. Our net gain will be $10.
 If the stock price is between $40 and $50, the only option to be exercised will be

option b, and we will gain the difference between $50 and the stock price.

If the stock price is between $50 and $60, the only option to be exercised will be a

call option and we will gain the difference between the stock price and $50.

If the stock price is above $60, then neither put will be exercised, but both calls

will be. We will be able to buy the stock for $50 using option a, but we will be forced to

sell it for $60 by the owner of option d. Our net gain will be $10.

20.27 Consider the payoff structures of the following two portfolios:

a. Buying a call option on one share in one month at a strike price of $50 and saving the

present value of $50 (so that at expiration it will have grown to $50 with interest).

b. Buying a put option on one share in one month at a strike price of $50 and buying

one share of stock.

What conclusion can you draw about the relation between call prices and put prices?

Solution:

The payoff of these two portfolios is identical. In the first case, if the stock price is below

$50 at expiration, you will not exercise and you will be left with $50. If it is above $50,

you will exercise and you will have a share of stock (whatever it is worth). In the second

case, if the price is below $50, you will exercise your put option and get $50 for your

share of stock. If it is above $50, you will not exercise and you will retain your share of

stock (whatever it is worth).

 From this, we can see that the value of the two portfolios today must be the same.

That is:

C + K / (1 + Rrf) = P + S

where C is the value of a call, P is the value of a put, both options have a strike price K

and the same expiration, S is the current value of the stock and Rrf is the risk-free interest

rate. If we know the value of a call (and the current stock price and interest rate), we can

calculate the value of a put. This relation is call put-call parity. Note that this relation is

not dependent on any option pricing model.

20.28 One way to extend the binomial pricing model is by including multiple time periods.

Suppose Splittime, Inc., is currently trading for $100 per share. In one month the price

will either increase by $10 (to $110) or decrease by $10 (to $90). The following month

will be the same. The price will either increase by $10 or decrease by $10. Note that in

two months, the price could be $120, $100, or $80. The risk-free rate is 1 percent per

month. Find the value today of an option to buy one share of Splittime in two months for

a strike price of $105. (Hint: To do this, first find the value of the option at each of the

two possible one-month prices. Then use those values as the payoffs at one month and

find the value today.)

Solution:

If the price of Splittime goes from $100 to $90 during the first month, then this option

will never be exercised because the highest price to which Splittime could rise by two
months is $100, which is lower than the strike price of $105. Therefore, the value of the

option in the down case is $0.

If the price rises to $110 in the first month, then the payoff of the option will be

either $15 (if the price continues to rise to $120) or $0 (if the price falls back to $100).

Stock (X) Risk-Free (Y) Option

One month $110 $1 ???

Expiration
$100 $120 $1.01 $1.01 $0 $15

These two equations define our portfolio:

$15 = $120 X + $1.01 Y

$0 = $100 X + $1.01 Y

The solution is X = 0.75 shares and Y = -$74.26. The value of this portfolio, and therefore

the value of the option at this point, is $8.24. (0.75 $110 $74.26).

Now we are ready to calculate the value of the option today using $0 and $8.24 as

the one-month option payoffs.

 Stock (X) Risk-Free (Y) Option

Today $100 $1 ???

One month
$90 $110 $1.01 $1.01 $0 $8.24

Now the equations that define our portfolio are

$8.24 = $110 X + $1.01 Y

$0 = $90 X + $1.01 Y

The solution is X = 0.412 and Y = -$36.71. The portfolio value is $4.50, and this is the

value of the option.

20.29 SpinTheWheel Co. current has assets currently worth $10 million in the form of one-year

risk-free bonds that will return 10 percent. The company has debt with a face value of

$5.5 million due in one year. (No interest payments will be made.) The stockholders

decided to sell $8 million of the risk-free bonds and to invest the money in a very risky

venture. This venture consists of Mr. William Kid taking the money now and, in one year,

flipping a coin. If it comes up heads, Mr. Kid will pay SpinTheWheel $17.6 million. If it

is tails, SpinTheWheel gets nothing. (Notice that this is a zero NPV investment.)

a. What is the value of the debt and equity before they make this investment?

b. Using the binomial pricing model, with the payoff to the equity holders representing

the option and the assets of the company representing the underlying asset, estimate

the value of the equity after they make the investment.

c. What is the new value of the debt after the investment?

Solution:

a. The firm is certain to have the $5.5 million owed to the debt holders in one year, so

the correct discount rate for the debt is the risk-free rate, 10 percent. Thus the value

today of the debt is the present value of the debt at the risk-free rate: $5.5 million /

1.1 = $5 million. The value of the equity is therefore $10 million $5 million = $5

million.

b. The payoffs of the option (the equity), the underlying (the firm), and the risk-free

bond are:

Firm Risk-Free (Y) Equity

Today $10 $1 ???

One year
$2.2 $19.8 $1.1 $1.1 $0 $14.
3

Note that the payoff of $14.3 for the option in the up case comes from the $19.8

million less the $5.5 million they will pay the bondholders. In the down case, there is

not enough money to pay the bondholders what they are owed, so the bondholders

will receive the entire $2.2 million value of the firm and the equity holders get

nothing.

The equations are:

 $14.3 = $19.8 X + $1.1 Y

$0 = $2.2 X + $1.1 Y

and the solution is X = 0.8125 and Y = -$1.625. The value of this portfolio is $6.5

million. This is the new value of the equity.

c. The current value of the firm did not change (this was a zero NPV project) and

remains at $10 million. If the equity has increased in value to $6.5 million, the debt

has decreased in value to $3.5 million.

20.30 The payoff function for straight debt looks like that for the seller of a put option.

Convertible debt is straight debt plus a call option on a firms stock. How does the

addition of a call option to straight debt affect the concern that lenders have about the

stockholders seeking riskier projects (the asset substitution problem), and why?

Solution:

It mitigates this concern because the lenders will benefit through the call option from

increased volatility in the value of the firm. How much a conversion option mitigates this

concern depends on the specific characteristics of the option.

Sample Test Problems

20.1 Draw the payoff diagram representing the payoff for a combination of buying a call with

a strike price of $40 and selling a call with a strike price of $50. What would the buyer of

such an option hope would happen to the stock price?

Solution:

The payoff diagram would look like this:

Value

$10

Stock price
$40 $50

This is called a collar. The buyer hopes that the stock price will go up (above $40).

Collars are used to limit the cost of the option position. They give up the gain for large

moves in exchange for lower cost up front.

20.2 Of the five variables identified as affecting the value of an option, which will have the

opposite impact on the value of a put as they do on the value of a call? That is, for which

variables will a given change increase the value of a call and decrease the value of a put

(or vice versa)?

Solution:

There are three such variables. An increase in the value of the underlying asset will

increase the value of a call and decrease the value of a put. An increase in the strike price

of the option will decrease the value of a call and increase the value of a put. An increase

in the risk-free interest rate will increase the value of a call and decrease the value of a

put. Both of the other two variables, the time to expiration and the volatility of the value

of the underlying asset, affect the value of puts and calls in the same direction.

20.3 What kinds of real options are being described?

a. Freds Cheap Cars buys the empty field adjacent to its car lot.

b. Midway through construction, MiniMax, Inc., stops construction of an office building

that it planned to use as a corporate headquarters.

c. Major Deals, a discount retailer, opens a new store in Mexico, its first.

Solution:

a. Fred is buying the option to expand his business.

b. MiniMax is exercising its option to abandon the project.

 c. Major Deals (in addition to other things) is gaining the option to expand its Mexican

presence in the future.

20.4 If you fail to account for the real options available in a given project, what error might

you make in your capital budgeting decision?

Solution:

You might reject a project that is positive NPV. Options are a valuable part of a project

that contains them. By including their value, we increase our estimate of the NPV of the

project, possibly from negative to positive.

20.5 Suppose you are a corn farmer. Assuming that there is an active market in corn

derivatives (futures and options), what trades might you want to use to protect yourself

against falling corn prices? What would be the cost of using them?

Solution:

You could buy puts on corn. This would allow you to benefit from upward movements in

corn prices while providing a minimum price at which you would be sure to be able to

sell. The downside is the immediate cost of buying the option.