Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 21

CHAPTER TWENTY-ONE VALUING OPTIONS In the last chapter we introduced you to call and put options. Call options give the owner the right to buy an asset at a specified exercise price; put options give the right to sell. We also took the first step toward understanding how options are valued. | Brealey-Meyers Principles of Corporate Finance Seventh Edition VI. Options 21. Valuing Options The McGraw-Hill Companies 2003 CHAPTER TWENTY-ONE Brealey-Meyers Principles of Corporate Finance Seventh Edition VI. Options 21. Valuing Options The McGraw-Hill Companies 2003 IN THE LAST chapter we introduced you to call and put options. Call options give the owner the right to buy an asset at a specified exercise price put options give the right to sell. We also took the first step toward understanding how options are valued. The value of a call option depends on five variables 1. The higher the price of the asset the more valuable an option to buy it. 2. The lower the price that you must pay to exercise the call the more valuable the option. 3. You do not need to pay the exercise price until the option expires. This delay is most valuable when the interest rate is high. 4. If the stock price is below the exercise price at maturity the call is valueless regardless of whether the price is 1 below or 100 below. However for every dollar that the stock price rises above the exercise price the option holder gains an additional dollar. Thus the value of the call option increases with the volatility of the stock price. 5. Finally a long-term option is more valuable than a short-term option. A distant maturity delays the point at which the holder needs to pay the exercise price and increases the chance of a large jump in the stock price before the option matures. In this chapter we show how these variables can be combined into an exact option-valuation model a formula we can plug numbers into to get a definite answer. We first describe a simple way to value options known as the binomial model. We then introduce the Black-Scholes formula for valuing options. Finally we provide a checklist showing how these two methods can be used to solve a number of practical option problems. The only feasible way to value most options is to use a computer. But in this chapter we will work .

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