Types of Options in Finance
Types of Options in Finance. Let start with a definition of Option. An option can be defined as the right to the holder, (but not the obligation) to buy or sell a given quantity of an asset on or before a given date in future, at prices agreed upon today. Many corporate securities are similar to the stock options that are traded on organized exchanges. Almost every issue of corporate stocks and bonds has option features. In addition, capital structure and capital budgeting decisions can be viewed in terms of options.
Options are of two types: call options and put options.
Call options give the holder the right, but not the obligation, to buy a given quantity of some asset within some time in the future called expiration date, at prices agreed upon today known striking price or exercise price. When exercising a call option, investors ‘call in’ the underlying asset.
Put options give 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, investors ‘put’ the asset to someone.
There are two parties in an option contract.
The investor getting the right to buy a specific number of shares in case of call option is called buyer. On the other hand, the investor wishing to sell a specified numbers of shares to the buyer of the option is referred to as seller. The option contract is initiated by the seller of the option and the seller is called the writer of the option. Let us take an example: Suppose the current market price of a share of a company is Tk. 200. A call option would give the right to buy the share at a specified price of Tk. 210 during the next 3 months.
◘ Call provision on a bond:
A call provision provides the issuer the right, but not the obligation to repurchase the bond at a specified price.
◘ Put bonds:
The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed price for a fixed period of time.
◘ Green Shoe provision:
The right of the underwriter to purchase additional shares from the issuer at the offer price in an IPO.
Insurance obligates the insurer (option writer) to purchase the underlying asset at a specified price for a specified period (the term of the policy).
Stocks and Bonds as Options
■ Levered Equity is a call option.
■ The underlying assets comprise the assets of the firm.
■ The strike price is the payoff of the bond.
■ If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money call, they will pay the bondholders and “call in” the assets of the firm.
■ If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire.
The value of a stock option depends on the following factors:
◘ Current price of underlying stock.
◘ Dividend yield of the underlying stock.
◘ Strike price specified in the option contract.
◘ Risk-free interest rate over the life of the contract.
◘ Time remaining until the option contract expires.
◘ Price volatility of the underlying stock.
Much of corporate financial theory can be presented in terms of options.
◘ Common stock in a levered firm can be viewed as a call option on the assets of the firm.
◘ Real projects often have hidden option that enhance value.