7-1

The Mechanics of
Finance 457

Options Markets

Chapter Seven
7-2

Mechanics of Options Markets

Finance 457

7.1 Underlying Assets

7.2 Specifications of stock options
7.3 Newspaper Quotes
7.4 Trading
7.5 Commissions
7.6 Margins
7.7 The Options Clearing Corporation
7.8 Regulation
7.9 Taxation
7.10 Warrants, ESOs and Convertibles
7.11 Over-the-counter markets
Summary and Conclusions
7-3

Options Contracts: Preliminaries

Finance 457

An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or perhaps
before) a given date, at prices agreed upon today.
Calls versus Puts
Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
When exercising a call option, you call in the asset.
Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you put the asset to someone.
7-4

Options Contracts: Preliminaries

Finance 457

Exercising the Option

The act of buying or selling the underlying asset through
the option contract.
Strike Price or Exercise Price
Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset.
Expiry
The maturity date of the option is referred to as the
expiration date, or the expiry.
European versus American options
European options can be exercised only at expiry.
American options can be exercised at any time up to expiry.
7-5

Options Contracts: Preliminaries

Finance 457

In-the-Money
The exercise price is less than the spot price of the
underlying asset.
At-the-Money
The exercise price is equal to the spot price of the
underlying asset.
Out-of-the-Money
The exercise price is more than the spot price of the
underlying asset.
7-6

Options Contracts: Preliminaries

Finance 457

Intrinsic Value
The difference between the exercise price of the option
and the spot price of the underlying asset.
Speculative Value
The difference between the option premium and the
intrinsic value of the option.

Option Intrinsic + Speculative

=
Premium Value Value
7-7

7.1 Underlying Assets

Finance 457

Stocks
CBOE, PHLX, AMEX, and the Pacific Exchange
Trade on more than 500 different stocks, on round lots
Stock indices
Settlement is always in cash.
Foreign Currencies
PHLX
European and American options on a variety of currencies
Futures Contracts
The futures contract normally matures just after the expiry of the
option
7-8

7.2 Specifications of stock options

Finance 457

Expiry Expiry Cycles:

10:59 CST on the Saturday January
immediately following the January, April, July, October
third Friday of the month. February
The last trading day is the February, May, August, November
third Friday.
March
Holder of the option has
March, June, September,
until 4:30 of that Friday to
exercise. December
His broker has until 10:59 When one option expires, trading in
the next day to notify the another begins.
exchange
7-9

7.2 Specifications of stock options

Finance 457

Strike Price Terminology:

When a new expiration date
is introduced, the two or
three strike prices closest to
the current stock price are
usually selected by the
exchange.
If the stock prices move
outside this range, new
options will be introduced.
An option class refers to all puts on
firm XYZ or all calls on ABC.
An option series consists of all the
options of a given class with the same
expiry and strike (e.g. the IBM
October 50 calls)
7-10

7.2 Specifications of stock options

Finance 457

Dividends and Splits Position Limits

Exchange traded options A position limit is the maximum
are adjusted for stock splits number of option contracts that an
and stock dividends. investor can hold on one side of
Exchange traded options the market.
are generally not adjusted Short calls and long puts are on
for cash dividends the same side.
Exercise Limits
Equals the position limit.
Controversial issue.
7-11

Reading The Wall Street Journal

Finance 457

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
7-12

Reading The Wall Street Journal

Finance 457

This option has a strike price of $135;

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
a recent price for the stock is $138.25
July is the expiration month
7-13

Reading The Wall Street Journal

Finance 457

This makes a call option with this exercise price in-the-

money by $3.25 = $138 $135.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7

Puts with this exercise price are out-of-the-money.

7-14

Reading The Wall Street Journal

Finance 457

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7

On this day, 2,365 call options with this exercise price were
traded.
7-15

Reading The Wall Street Journal

Finance 457

The CALL option with a strike price of $135 is trading for

$4.75.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions.
7-16

Reading The Wall Street Journal

Finance 457

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
On this day, 2,431 put options with this exercise price were
traded.
7-17

Reading The Wall Street Journal

Finance 457

The PUT option with a strike price of $135 is trading for

$.8125.
--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions.
7-18
7.4 Trading
Finance 457
Market Makers
Offer bid and ask quotes on
the option.
Market makers ensure that
buy and sell orders can
always be executed at some
price without delay.
The bid-ask spread is their
compensation for this
liquidity intermediation
Offsetting Orders
An investor can close out a
long position by issuing an
offsetting order to sell the
same option.
An investor can close out a
short position by issuing an
offsetting order to buy the
same option.
7-19

7.5 Commissions
Finance 457

Commissions vary substantially A hidden cost is the bid-ask

from one broker to another. spread
7-20

7.6 Margins
Finance 457

Since options already have plenty of leverage, option premia must be

paid in full.
7-21

7.6 Margins
Finance 457

Naked
If you write a call on shares you dont own.
The initial margin is the greater of:
100% of the proceeds plus 20% of the underlying share price
less the amount if any by which the option is out of the money
100% of the option proceeds plus 10% of the underlying share
price
Covered Call
IF the option is out of the money, no margin is required
7-22
7.7 The Options Clearing Corporation
Finance 457
Has the same function as the
clearinghouse in the futures
markets.
Guarantees option writers fulfill
their obligations and keeps a
record of all long and short
positions.
Exercising an option
The OCC randomly selects a
member with an outstanding
short position in the option.
The member then selects a
particular investor who has
written the option.
At expiry, all in-the-money
options should be exercised
unless transactions costs are too
high.
7-23

7.8 Regulation
Finance 457

Both the exchange and the OCC There havent been any huge
have rules governing the scandals, so we leave them
behavior of traders. alone.
Both federal and state regulatory So far
authorities exist.
SEC CFTC
7-24

7.9 Taxation
Finance 457

Determining the tax implications

of options strategies can be
tricky.
7-25
7.10 Warrants, Executive Stock Options and
Convertibles
Finance 457

The important questions are:

How can warrants and convertibles be valued?
What impact do warrants and convertibles have on firm
value?
What are the differences between warrants, convertibles
and call options?
Under what circumstances are warrants and convertibles
converted into common stock?
7-26

Warrants
Finance 457

Warrants are call options that give the holder the right, but
not the obligation, to buy shares of common stock directly
from a company at a fixed price for a given period of time.
Warrants tend to have longer maturity periods than exchange
traded options.
Warrants are generally issued with privately placed bonds as
an equity kicker.
Warrants are also combined with new issues of common
stock and preferred stock, given to investment bankers as
compensation for underwriting services.
In this case, they are often referred to as a Green Shoe
Option.
7-27

The Difference Between Warrants and

Finance 457

Call Options
When a warrant is exercised, a firm must issue new
shares of stock.
This can have the effect of diluting the claims of
existing shareholders.
7-28

Dilution Example
Finance 457

Imagine that Mr. Armstrong and Mr. LeMond are

shareholders in a firm whose only asset is 10 ounces of gold.
When they incorporated, each man contributed 5 ounces of
gold, then valued at $300 per ounce. They printed up two
stock certificates, and named the firm LegStrong, Inc..
Suppose that Mr. Armstrong decides to sell Mr. Mercx a call
option issued on Mr. Armstrongs share. The call gives Mr.
Mercx the option to buy Mr. Armstongs share for $1,500.
If this call finishes in-the-money, Mr. Mercx will exercise,
Mr. Armstrong will tender his share.
Nothing will change for the firm except the names of the
shareholders.
7-29

Dilution Example
Finance 457

Suppose that Mr. Armstrong and Mr. LeMond meet as the

board of directors of LegStrong. The board decides to sell
Mr. Mercx a warrant. The warrant gives Mr. Mercx the
option to buy one share for $1,500.
Suppose the warrant finishes in-the-money, (gold increased
to $350 per ounce). Mr. Mercx will exercise. The firm will
print up one new share.
7-30

Dilution Example
Finance 457

The balance sheet of LegStrong Inc. would change in the

following way:
Balance Sheet Before
(Book Value)
Assets Liabilities and
Equity
Gold: $3,000 Debt 0
Equity $3,000
(2 shares)
Total Assets $3,000 Total $3,000
7-31

Dilution
Finance 457

The balance sheet of LegStrong Inc. would change in the

following way:

Balance Sheet Before

(Market Value)
Assets Liabilities and
Equity
Gold: $3,500 Debt 0
Equity $3,500
(2 shares)
Total Assets $3,500 Total $3,500
7-32

Dilution
Finance 457

The balance sheet of LegStrong Inc. would change in the

following way:
Balance Sheet After
(Market Value)
Assets Liabilities and
Equity
Gold: $3,500 Debt 0
Cash: $1,500 Equity $5,000
(3 shares)
Total Assets $5,000 Total $5,000

Note that Mr. Armstrongs claim falls in value from

$1,750 = $3,500 2 to $1,666.67 = $5,000 3
7-33

Convertible Bonds
Finance 457

A convertible bond is similar to a bond with warrants.

The most important difference is that a bond with warrants
can be separated into different securities and a convertible
bond cannot.
Recall that the minimum (floor) value of convertible:
Straight or intrinsic bond value
Conversion value
The conversion option has value.
7-34

The Value of Convertible Bonds

Finance 457

The value of a convertible bond has three components:

1. Straight bond value
2. Conversion value
3. Option value
7-35

Convertible Bond Problem

Finance 457

Litespeed, Inc., just issued a zero coupon convertible bond

due in 10 years.
The conversion ratio is 25 shares.
The appropriate interest rate is 10%.
The current stock price is $12 per share.
Each convertible is trading at $400 in the market.
What is the straight bond value?
What is the conversion value?
What is the option value of the bond?
7-36

Convertible Bond Problem (continued)

Finance 457

What is the straight bond value?

$1,000
SBV 10
$385.54
(1.10)
What is the conversion value?

25 shares $12/share = $300

What is the option value of the bond?

$400 385.54 = $14.46

7-37

The Value of Convertible Bonds

Finance 457

Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
= conversion ratio Option
value
Stock
Price
7-38

Reasons for Issuing Warrants and Convertibles

Finance 457

A reasonable place to start is to compare a hybrid like

convertible debt to both straight debt and straight equity.
Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
Since convertible debt is originally issued with an out-of-
the-money call option, one can argue that convertible debt
allows the firm to sell equity at a higher price than is
available at the time of issuance. However, the same
argument can be used to say that it forces the firm to sell
equity at a lower price than is available at the time of
exercise.
7-39

Convertible Debt vs. Straight Debt

Finance 457

Convertible debt carries a lower coupon rate than does otherwise-

identical straight debt.
If the company subsequently does poorly, it will turn out that the
conversion option finishes out-of-the-money.
But if the stock price does well, the firm would have been better off
issuing straight debt.
In an efficient financial market, convertible bonds will be neither
cheaper or more expensive than other financial instruments.
At the time of issuance, investors pay the firm for the fair value of
the conversion option.
7-40

Convertible Debt vs. Straight Equity

Finance 457

If the company subsequently does poorly, it will turn out

that the conversion option finishes out-of-the-money, but
the firm would have been even better off selling equity
when the price was high.
But if the stock price does well, the firm is better off
issuing convertible debt rather than equity
In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
At the time of issuance, investors pay the firm for the fair
value of the conversion option
7-41
Why Warrants and Convertibles are Issued
Finance 457

Convertible bonds reduce agency costs, by aligning the

incentives of stockholders and bondholders.
Convertible bonds also allow young firms to delay
expensive interest costs until they can afford them.
Support for these assertions is found in the fact that firms
that issue convertible bonds are different from other firms:
The bond ratings of firms using convertibles are lower.
Convertibles tend to be used by smaller firms with high
growth rates and more financial leverage.
Convertibles are usually subordinated and unsecured.
7-42

Conversion Policy
Finance 457

Most convertible bonds are also callable.

When the bond is called, bondholders have about 30 days to choose
between:
1. Converting the bond to common stock at the conversion ratios.
2. Surrendering the bond and receiving the call price in cash.
From the shareholders perspective, the optimal call policy is to call
the bond when its value is equal to the call price.
In the real world, most firms wait to call until the bond value is
substantially above the call price. Perhaps the firm is afraid of
the risk of a sharp drop in stock prices during the 30-day
window.
7-43
Executive Stock Options
Finance 457

Executive Stock Options exist to align the interests of

shareholders and managers.
Executive Stock Options are call options (technically
warrants) on the employers shares.
Inalienable
Typical maturity is 10 years.
Typical vesting period is 3 years.
Most include implicit reset provision to preserve
incentive compatibility.
Executive Stock Options give executives an important tax
break: grants of at-the-money options are not considered
taxable income. (Taxes are due if the option is exercised.)
7-44
Valuing Executive Compensation
Finance 457

FASB allows firms to record zero expense for grants of at-

the-money executive stock options.
However the economic value of a long-lived call option is
enormous, especially given the propensity of firms to reset
the exercise price after drops in the price of the stock.
Due to the inalienability, the options are worth less to the
executive than they cost the company.
The executive can only exercise, not sell his options.
Thus he can never capture the speculative valueonly
the intrinsic value.
This dead weight loss is overcome by the incentive
compatibility for the grantor.
7-45
Top Stock Option Grants
Finance 457

Company CEO Stock Option Award

Citigroup, Inc. Sanford Weill $351,319,000

American Express Harvey Golub $134,102,000
Cisco Systems, Inc. John Chambers $132,100,000

Bank of America Hugh McColl Jr. $104,300,000

Honeywell Inc. Michael Bosignore $121,496,000

ALCOA Paul ONeill $96,353,000

7-46

7.11 Over-the-counter markets

Finance 457
7-47

Summary and Conclusions

Finance 457