### Options on a Stock That Pays Dividends

*• Early exercise must be considered.*

*• Proportional dividend payout model is tractable (see*
text).

**– The dividend amount is a constant proportion of the**
*prevailing stock price.*

*• In general, the corporate dividend policy is a complex*
issue.

### Known Dividends

*• Constant dividends introduce complications.*

*• Use D to denote the amount of the dividend.*

*• Suppose an ex-dividend date falls in the ﬁrst period.*

*• At the end of that period, the possible stock prices are*
*Su − D and Sd − D.*

*• Follow the stock price one more period.*

*• The number of possible stock prices is not three but*
*four: (Su − D) u, (Su − D) d, (Sd − D) u, (Sd − D) d.*

**– The binomial tree no longer combines.**

*(Su − D) u*

*Su − D*

*(Su − D) d*
*S*

*(Sd − D) u*

*Sd − D*

*(Sd − D) d*

### An Ad-Hoc Approximation

*• Use the Black-Scholes formula with the stock price*
reduced by the PV of the dividends.^{a}

*• This essentially decomposes the stock price into a*
riskless one paying known dividends and a risky one.

*• The riskless component at any time is the PV of future*
dividends during the life of the option.

**– Then, σ is the volatility of the process followed by***the risky component.*

*• The stock price, between two adjacent ex-dividend*
dates, follows the same lognormal distribution.

aRoll (1977); Heath & Jarrow (1988).

### An Ad-Hoc Approximation (concluded)

*• Start with the current stock price minus the PV of*
future dividends before expiration.

*• Develop the binomial tree for the new stock price as if*
there were no dividends.

*• Then add to each stock price on the tree the PV of all*
*future dividends before expiration.*

*• American option prices can be computed as before on*
this tree of stock prices.

### The Ad-Hoc Approximation vs. P. 324 (Step 1)

*S − D/R*

*

j

*(S − D/R)u*

*

j

*(S − D/R)d*

*

j

*(S − D/R)u*^{2}

*(S − D/R)ud*

*(S − D/R)d*^{2}

### The Ad-Hoc Approximation vs. P. 324 (Step 2)

*(S − D/R) + D/R = S*

*

j

*(S − D/R)u*

*

j

*(S − D/R)d*

*

j

*(S − D/R)u*^{2}

*(S − D/R)ud*

*(S − D/R)d*^{2}

### The Ad-Hoc Approximation vs. P. 324

^{a}

*• The trees are diﬀerent.*

*• The stock prices at maturity are also diﬀerent.*

* – (Su − D) u, (Su − D) d, (Sd − D) u, (Sd − D) d*
(p. 324).

**– (S − D/R)u**^{2}*, (S − D/R)ud, (S − D/R)d*^{2} (ad hoc).

*• Note that, as d < R < u,*

*(Su − D) u > (S − D/R)u*^{2}*,*
*(Sd − D) d < (S − D/R)d*^{2}*,*

aContributed by Mr. Yang, Jui-Chung (D97723002) on March 18, 2009.

### The Ad-Hoc Approximation vs. P. 324 (concluded)

*• So the ad hoc approximation has a smaller dynamic*
range.

*• This explains why in practice the volatility is usually*
*increased when using the ad hoc approximation.*

### A General Approach

^{a}

*• A new tree structure.*

*• No approximation assumptions are made.*

*• A mathematical proof that the tree can always be*
constructed.

*• The actual performance is quadratic except in*
pathological cases (see pp. 789ﬀ).

*• Other approaches include adjusting σ and approximating*
the known dividend with a dividend yield.^{b}

aDai (B82506025, R86526008, D8852600) & Lyuu (2004). Also Arealy

& Rodrigues (2013).

bGeske & Shastri (1985). It works well for American options but not European ones (Dai, 2009).

### Continuous Dividend Yields

*• Dividends are paid continuously.*

**– Approximates a broad-based stock market portfolio.**

*• The payment of a continuous dividend yield at rate q*
*reduces the growth rate of the stock price by q.*

**– A stock that grows from S to S*** _{τ}* with a continuous

*dividend yield of q would have grown from S to*

*S*

_{τ}*e*

*without the dividends.*

^{qτ}*• A European option has the same value as one on a stock*
*with price Se*^{−qτ}*that pays no dividends.*^{a}

a*In pricing European options, only the distribution of S**τ* matters.

### Continuous Dividend Yields (continued)

*• So the Black-Scholes formulas hold with S replaced by*
*Se** ^{−qτ}*:

^{a}

*C = Se*^{−qτ}*N (x) − Xe*^{−rτ}*N (x − σ√*

*τ ),* (44)
*P = Xe*^{−rτ}*N (−x + σ√*

*τ ) − Se*^{−qτ}*N (−x),*

(44* ^{}*)
where

*x* =^{Δ} *ln(S/X) +*

*r − q + σ*^{2}*/2*
*τ*
*σ√*

*τ* *.*

*• Formulas (44) and (44** ^{}*) remain valid as long as the
dividend yield is predictable.

aMerton (1973).

### Continuous Dividend Yields (continued)

*• To run binomial tree algorithms, replace u with ue*^{−qΔt}*and d with de*^{−qΔt}*, where Δt* *= τ /n.*^{Δ}

**– The reason: The stock price grows at an expected**
*rate of r − q in a risk-neutral economy.*

*• Other than the changes, binomial tree algorithms stay*
the same.

**– In particular, p should use the original u and d!**^{a}

aContributed by Ms. Wang, Chuan-Ju (F95922018) on May 2, 2007.

### Continuous Dividend Yields (concluded)

*• Alternatively, pick the risk-neutral probability as*
*e*^{(r−q) Δt}*− d*

*u − d* *,* (45)

*where Δt* *= τ /n.*^{Δ}

**– The reason: The stock price grows at an expected**
*rate of r − q in a risk-neutral economy.*

*• The u and d remain unchanged.*

*• Except the change in Eq. (45), binomial tree algorithms*
*stay the same as if there were no dividends.*

### Distribution of Logarithmic Returns of TAIEX

### Exercise Boundaries of American Options (in the Continuous-Time Model)

^{a}

*• The exercise boundary is a nondecreasing function of t*
*for American puts (see the plot next page).*

*• The exercise boundary is a nonincreasing function of t*
for American calls.

aSee Section 9.7 of the textbook for the tree analog.

*Sensitivity Analysis of Options*

Cleopatra’s nose, had it been shorter, the whole face of the world would have been changed.

— Blaise Pascal (1623–1662)

### Sensitivity Measures (“The Greeks”)

*• How the value of a security changes relative to changes*
in a given parameter is key to hedging.

**– Duration, for instance.**

*• Let x* =^{Δ} *ln(S/X)+(r+σ*^{2}*/2) τ*
*σ**√*

*τ* (recall p. 303).

*• Recall that*

*N*^{}*(y) =* *e√*^{−y}^{2}^{/2}

*2π* *> 0,*

the density function of standard normal distribution.

### Delta

*• Deﬁned as*

Δ =^{Δ} *∂f*

*∂S.*
**– f is the price of the derivative.**

**– S is the price of the underlying asset.**

*• The delta of a portfolio of derivatives on the same*

underlying asset is the sum of their individual deltas.^{a}

*• The delta used in the BOPM (p. 249) is the discrete*
analog.

*• The delta of a long stock is 1.*

aElementary calculus.

### Delta (continued)

*• The delta of a European call on a non-dividend-paying*
stock equals

*∂C*

*∂S* *= N (x) > 0.* (46)

*• The delta of a European put equals*

*∂P*

*∂S* *= N (x) − 1 = −N (−x) < 0.* (47)

*• So the deltas of a call and an otherwise identical put*
*cancel each other when N (x) = 1/2, i.e., when*^{a}

*X = Se*^{(r+σ}^{2}^{/2) τ}*.* (48)

a*The straddle (p. 213) C + P then has zero delta!*

0 50 100 150 200 250 300 350 Time to expiration (days) 0

0.2 0.4 0.6 0.8 1

Delta (call)

0 50 100 150 200 250 300 350 Time to expiration (days) -1

-0.8 -0.6 -0.4 -0.2 0

Delta (put)

0 20 40 60 80

Stock price 0

0.2 0.4 0.6 0.8 1

Delta (call)

0 20 40 60 80

Stock price -1

-0.8 -0.6 -0.4 -0.2 0

Delta (put)

Dotted curve: in-the-money call or out-of-the-money put.

Solid curves: at-the-money options.

Dashed curves: out-of-the-money calls or in-the-money puts.

### Delta (continued)

*• Suppose the stock pays a continuous dividend yield of q.*

*• Let*

*x* =^{Δ} *ln(S/X) +*

*r − q + σ*^{2}*/2*
*τ*
*σ√*

*τ* (49)

(recall p. 333).

*• Then*

*∂C*

*∂S* = *e*^{−qτ}*N (x) > 0,*

*∂P*

*∂S* = *−e*^{−qτ}*N (−x) < 0.*

### Delta (continued)

*• Consider an X*_{1}*-strike call and an X*_{2}-strike put,
*X*_{1} *≥ X*_{2}.

*• They are otherwise identical.*

*• Let*

*x** _{i}* =

^{Δ}

*ln(S/X*

*) +*

_{i}*r − q + σ*^{2}*/2*
*τ*
*σ√*

*τ* *.* (50)

*• Then their deltas sum to zero when x*1 = *−x*2.^{a}

*• That implies*

*S*

*X*1 = *X*_{2}

*S* *e*^{−(2r−2q+σ}^{2}^{) τ}*.* (51)

a*The strangle (p. 215) C + P then has zero delta!*

### Delta (concluded)

*• Suppose we demand X*_{1} *= X*_{2} *= X and have a straddle.*

*• Then*

*X = Se*^{(r−q+σ}^{2}* ^{/2) τ}*
leads to a straddle with zero delta.

**– This generalizes Eq. (48) on p. 343.**

*• When C(X*1*)’s delta and P (X*2)’s delta sum to zero,
*does the portfolio C(X*1) *− P (X*2) have zero value?

*• In general, no.*

### Delta Neutrality

*• A position with a total delta equal to 0 is delta-neutral.*

* – A delta-neutral portfolio is immune to small price*
changes in the underlying asset.

*• Creating one serves for hedging purposes.*

* – A portfolio consisting of a call and −Δ shares of*
stock is delta-neutral.

**– Short Δ shares of stock to hedge a long call.**

**– Long Δ shares of stock to hedge a short call.**

*• In general, hedge a position in a security with delta Δ*_{1}
by shorting Δ_{1}*/Δ*_{2} units of a security with delta Δ_{2}.

### Theta (Time Decay)

*• Deﬁned as the rate of change of a security’s value with*
respect to time, or Θ =^{Δ} *−∂f/∂τ = ∂f/∂t.*

*• For a European call on a non-dividend-paying stock,*
Θ = *−SN*^{}*(x) σ*

2*√*

*τ* *− rXe*^{−rτ}*N (x − σ√*

*τ ) < 0.*

**– The call loses value with the passage of time.**

*• For a European put,*
Θ = *−SN*^{}*(x) σ*

2*√*

*τ* *+ rXe*^{−rτ}*N (−x + σ√*
*τ ).*

**– Can be negative or positive.**

0 50 100 150 200 250 300 350 Time to expiration (days) -60

-50 -40 -30 -20 -10 0

Theta (call)

0 50 100 150 200 250 300 350 Time to expiration (days) -50

-40 -30 -20 -10 0

Theta (put)

0 20 40 60 80

Stock price -6

-5 -4 -3 -2 -1 0

Theta (call)

0 20 40 60 80

Stock price -2

-1 0 1 2 3

Theta (put)

Dotted curve: in-the-money call or out-of-the-money put.

Solid curves: at-the-money options.

Dashed curve: out-of-the-money call or in-the-money put.

### Theta (concluded)

*• Suppose the stock pays a continuous dividend yield of q.*

*• Deﬁne x as in Eq. (49) on p. 345.*

*• For a European call, add an extra term to the earlier*
formula for the theta:

Θ = *−SN*^{}*(x) σ*
2*√*

*τ* *− rXe*^{−rτ}*N (x − σ√*

*τ ) + qSe*^{−qτ}*N (x).*

*• For a European put, add an extra term to the earlier*
formula for the theta:

Θ = *−SN*^{}*(x) σ*
2*√*

*τ* *+rXe*^{−rτ}*N (−x+σ√*

*τ )−qSe*^{−qτ}*N (−x).*

### Gamma

*• Deﬁned as the rate of change of its delta with respect to*
the price of the underlying asset, or Γ *= ∂*^{Δ} ^{2}*Π/∂S*^{2}.

*• Measures how sensitive delta is to changes in the price of*
the underlying asset.

*• In practice, a portfolio with a high gamma needs be*
rebalanced more often to maintain delta neutrality.

*• Roughly, delta ∼ duration, and gamma ∼ convexity.*

*• The gamma of a European call or put on a*
non-dividend-paying stock is

*N*^{}*(x)/(Sσ√*

*τ ) > 0.*

0 20 40 60 80 Stock price

0 0.01 0.02 0.03 0.04

Gamma (call/put)

0 50 100 150 200 250 300 350 Time to expiration (days) 0

0.1 0.2 0.3 0.4 0.5

Gamma (call/put)

Dotted lines: in-the-money call or out-of-the-money put.

Solid lines: at-the-money option.

Dashed lines: out-of-the-money call or in-the-money put.

### Vega

^{a}

### (Lambda, Kappa, Sigma)

*• Deﬁned as the rate of change of a security’s value with*
respect to the volatility of the underlying asset

Λ =^{Δ} *∂f*

*∂σ.*

*• Volatility often changes over time.*

*• A security with a high vega is very sensitive to small*
changes or estimation error in volatility.

*• The vega of a European call or put on a*
*non-dividend-paying stock is S√*

*τ N*^{}*(x) > 0.*

**– So higher volatility always increases the option value.**

aVega is not Greek.

### Vega (continued)

*• Note that*^{a}

*Λ = τ σS*^{2}*Γ.*

*• If the stock pays a continuous dividend yield of q, then*
*Λ = Se*^{−qτ}*√*

*τ N*^{}*(x),*
*where x is deﬁned in Eq. (49) on p. 345.*

*• Vega is maximized when x = 0, i.e., when*
*S = Xe*^{−(r−q+σ}^{2}^{/2) τ}*.*

*• Vega declines very fast as S moves away from that peak.*

aReiss & Wystup (2001).

### Vega (continued)

*• Now consider a portfolio consisting of an X*1-strike call
*C and a short X*_{2}*-strike put P , X*_{1} *≥ X*_{2}.

*• The options’ vegas cancel out when*
*x*1 = *−x*2*,*

*where x** _{i}* are deﬁned in Eq. (50) on p. 346.

*• This also leads to Eq. (51) on p. 346.*

**– Recall the same condition led to zero delta for the**
*strangle C + P (p. 346).*

### Vega (concluded)

*• Note that τ → 0 implies*

Λ *→ 0*

(which answers the question on p. 308).

*• The Black-Scholes formula (p. 303) implies*

*C* *→ S,*

*P* *→ Xe*^{−rτ}*,*
*as σ → ∞.*

*• These boundary conditions are handy for some*
numerical methods.

0 20 40 60 80 Stock price

0 2 4 6 8 10 12 14

Vega (call/put)

50 100 150 200 250 300 350 Time to expiration (days) 0

2.5 5 7.5 10 12.5 15 17.5

Vega (call/put)

Dotted curve: in-the-money call or out-of-the-money put.

Solid curves: at-the-money option.

Dashed curve: out-of-the-money call or in-the-money put.

### Variance Vega

^{a}

*• Deﬁned as the rate of change of a security’s value with*
respect to the variance (square of volatility) of the

underlying asset

variance vega =^{Δ} *∂f*

*∂σ*^{2}*.*
**– Note that it is not deﬁned as ∂**^{2}*f /∂σ*^{2}!

*• It is easy to verify that*

variance vega = Λ
*2σ.*

aDemeterﬁ, Derman, Kamal, & Zou (1999).

### Volga (Vomma, Volatility Gamma, Vega Convexity)

*• Deﬁned as the rate of change of a security’s vega with*
respect to the volatility of the underlying asset

volga =^{Δ} *∂Λ*

*∂σ* = *∂*^{2}*f*

*∂σ*^{2} *.*

*• It can be shown that*

volga = Λ *x(x − σ√*
*τ )*
*σ*

= Λ

*σ*

ln^{2}*(S/X)*

*σ*^{2}*τ* *−* *σ*^{2}*τ*
4

*,*
*where x is deﬁned in Eq. (49) on p. 345.*^{a}

aDerman & M. B. Miller (2016).

### Volga (concluded)

*• Volga is zero when S = Xe*^{±σ}^{2}* ^{τ /2}*.

*• For typical values of σ and τ, volga is positive except*
*where S ≈ X.*

*• Volga can be used to measure the 4th moment of the*
underlying asset and the volatility of volatility.^{a}

aBennett (2014).

### Rho

*• Deﬁned as the rate of change in its value with respect to*
interest rates

*ρ* =^{Δ} *∂f*

*∂r* *.*

*• The rho of a European call on a non-dividend-paying*
stock is

*Xτ e*^{−rτ}*N (x − σ√*

*τ ) > 0.*

*• The rho of a European put on a non-dividend-paying*
stock is

*−Xτe*^{−rτ}*N (−x + σ√*

*τ ) < 0.*

50 100 150 200 250 300 350 Time to expiration (days) 0

5 10 15 20 25 30 35

Rho (call)

50 100 150 200 250 300 350 Time to expiration (days) -30

-25 -20 -15 -10 -5 0

Rho (put)

0 20 40 60 80

Stock price 0

5 10 15 20 25

Rho (call)

0 20 40 60 80

Stock price -25

-20 -15 -10 -5 0

Rho (put)

Dotted curves: in-the-money call or out-of-the-money put.

Solid curves: at-the-money option.

Dashed curves: out-of-the-money call or in-the-money put.

### Numerical Greeks

*• Needed when closed-form formulas do not exist.*

*• Take delta as an example.*

*• A standard method computes the ﬁnite diﬀerence,*
*f (S + ΔS) − f (S − ΔS)*

*2ΔS* *.*

*• The computation time roughly doubles that for*
evaluating the derivative security itself.

### An Alternative Numerical Delta

^{a}

*• Use intermediate results of the binomial tree algorithm.*

*• When the algorithm reaches the end of the ﬁrst period,*
*f*_{u}*and f** _{d}* are computed.

*• These values correspond to derivative values at stock*
*prices Su and Sd, respectively.*

*• Delta is approximated by*

*f*_{u}*− f*_{d}

*Su − Sd.* (52)

*• Essentially zero extra cost.*

aPelsser & Vorst (1994).

*S/(ud)*

*S/d*

*S/u*

*Su/d*

*S*

*Sd/u*

*Su*

*Sd*
*Suu/d*

*Sdd/u*

*Suuu/d*

*Suu*

*S*

*Sdd*

*Sddd/u*

### Numerical Gamma

*• At the stock price (Suu + Sud)/2, delta is*
*approximately (f*_{uu}*− f*_{ud}*)/(Suu − Sud).*

*• At the stock price (Sud + Sdd)/2, delta is*
*approximately (f*_{ud}*− f*_{dd}*)/(Sud − Sdd).*

*• Gamma is the rate of change in deltas between*
*(Suu + Sud)/2 and (Sud + Sdd)/2, that is,*

*f**uu**−f**ud*

*Suu−Sud* *−* _{Sud−Sdd}^{f}^{ud}^{−f}^{dd}

*(Suu − Sdd)/2* *.* (53)

### Alternative Numerical Delta and Gamma

^{a}

*• Let ≡ ln u.*

*• Think in terms of ln S.*

*• Then*

*f*_{u}*− f*_{d}*2*

1
*S*
approximates the numerical delta.

*• And*

*f*_{uu}*− 2f*_{ud}*+ f*_{dd}

^{2} *−* *f*_{uu}*− f*_{dd}*2*

1
*S*^{2}
approximates the numerical gamma.

aSee p. 688.

### Finite Diﬀerence Fails for Numerical Gamma

*• Numerical diﬀerentiation gives*

*f (S + ΔS) − 2f (S) + f (S − ΔS)*

*(ΔS)*^{2} *.*

*• It does not work (see text for the reason).*

*• In general, calculating gamma is a hard problem*
numerically.^{a}

*• But why did the binomial tree version work?*

aRecall p. 115.

### Other Numerical Greeks

*• The theta can be computed as*
*f*_{ud}*− f*

*2(τ /n)* *.*

**– In fact, the theta of a European option can be**
derived from delta and gamma.^{a}

*• The vega of a European option can be derived from*
gamma.^{b}

*• For rho, there seems no alternative but to run the*
binomial tree algorithm twice.^{c}

aSee p. 687.

bRecall p. 355.

cBut see p. 874 and pp. 1069ﬀ.

*Extensions of Options Theory*

As I never learnt mathematics, so I have had to think.

— Joan Robinson (1903–1983)

### Pricing Corporate Securities

^{a}

*• Interpret the underlying asset as the ﬁrm’s total value.*^{b}

*• The option pricing methodology can be applied to price*
corporate securities.

*• The result is called the structural model.*

*• Assumptions:*

**– A ﬁrm can ﬁnance payouts by the sale of assets.**

**– If a promised payment to an obligation other than**
stock is missed, the claim holders take ownership of
the ﬁrm and the stockholders get nothing.

aBlack & Scholes (1973); Merton (1974).

bMore realistic models posit ﬁrm value = asset value + tax beneﬁts*−*
bankruptcy costs (Leland & Toft, 1996).

### Risky Zero-Coupon Bonds and Stock

*• Consider XYZ.com.*

*• Capital structure:*

**– n shares of its own common stock, S.**

**– Zero-coupon bonds with an aggregate par value of X.**

*• What is the value of the bonds, B?*

*• What is the value of the XYZ.com stock, S?*

### Risky Zero-Coupon Bonds and Stock (continued)

*• On the bonds’ maturity date, suppose the total value of*
*the ﬁrm V* ^{∗}*is less than the bondholders’ claim X.*

*• Then the ﬁrm declares bankruptcy, and the stock*
becomes worthless.

*• If V* ^{∗}*> X, then the bondholders obtain X and the*
*stockholders V* ^{∗}*− X.*

*V* ^{∗}*≤ X V* ^{∗}*> X*

Bonds *V* ^{∗}*X*

Stock 0 *V* ^{∗}*− X*

### Risky Zero-Coupon Bonds and Stock (continued)

*• The stock has the same payoﬀ as a call!*

*• It is a call on the total value of the ﬁrm with a strike*
*price of X and an expiration date equal to the bonds’.*

**– This call provides the limited liability for the**
stockholders.

*• The bonds are a covered call*^{a} on the total value of the
ﬁrm.

*• Let V stand for the total value of the ﬁrm.*

*• Let C stand for a call on V .*

aRecall p. 202.

### Risky Zero-Coupon Bonds and Stock (continued)

*• Thus*

*nS* = *C (market capitalization of XYZ.com),*
*B* = *V − C.*

*• Knowing C amounts to knowing how the value of the*
ﬁrm is divided between stockholders and bondholders.

*• Whatever the value of C, the total value of the stock*
*and bonds at maturity remains V* * ^{∗}*.

*• The relative size of debt and equity is irrelevant to the*
*ﬁrm’s current value V .*

### Risky Zero-Coupon Bonds and Stock (continued)

*• From Theorem 11 (p. 303) and the put-call parity,*^{a}
*nS* = *V N (x) − Xe*^{−rτ}*N (x − σ√*

*τ ),* (54)
*B* = *V N (−x) + Xe*^{−rτ}*N (x − σ√*

*τ ).* (55)
**– Above,**

*x* =^{Δ} *ln(V /X) + (r + σ*^{2}*/2)τ*
*σ√*

*τ* *.*

*• The continuously compounded yield to maturity of the*
ﬁrm’s bond is

*ln(X/B)*

*τ* *.*

aThis is sometimes called Merton’s (1974) structural model.

### Risky Zero-Coupon Bonds and Stock (continued)

*• Deﬁne the credit spread or default premium as the yield*
diﬀerence between risky and riskless bonds,

*ln(X/B)*

*τ* *− r*

= *−*1
*τ* ln

*N (−z) +* 1

*ω* *N (z − σ√*
*τ )*

*.*
**– ω***= Xe*^{Δ} ^{−rτ}*/V .*

**– z***= ln ω/(σ*^{Δ} *√*

*τ ) + (1/2) σ√*

*τ = −x + σ√*
*τ .*
**– Note that ω is the debt-to-total-value ratio.**

### Risky Zero-Coupon Bonds and Stock (concluded)

*• In general, suppose the ﬁrm has a dividend yield at rate*
*q and the bankruptcy costs are a constant proportion α*
of the remaining ﬁrm value.

*• Then Eqs. (54)–(55) on p. 378 become, respectively,*
*nS* = *V e*^{−qτ}*N (x) − Xe*^{−rτ}*N (x − σ√*

*τ ),*

*B* = (1 *− α)V e*^{−qτ}*N (−x) + Xe*^{−rτ}*N (x − σ√*
*τ ).*

**– Above,**

*x* =^{Δ} *ln(V /X) + (r − q + σ*^{2}*/2)τ*
*σ√*

*τ* *.*

### A Numerical Example

*• XYZ.com’s assets consist of 1,000 shares of Merck as of*
March 20, 1995.

**– Merck’s market value per share is $44.5.**

*• It issues 1,000 shares of XYZ.com common stock and 30*
zero-coupon bonds maturing on July 21, 1995.

*• Each bond promises to pay $1,000 at maturity.*

*• n = 1, 000, V = 44.5 × n = 44, 500, and*
*X = 30 × 1, 000 = 30, 000.*

*• As Merck calls are being traded, we do not need*
formulas to price them.

—Call— —Put—

Option Strike Exp. Vol. Last Vol. Last
**Merck** 30 Jul 328 15^{1/4} *. . .* *. . .*

44^{1/2} 35 Jul 150 9^{1/2} 10 ^{1/16}
44^{1/2} 40 Apr 887 4^{3/4} 136 ^{1/16}
44^{1/2} 40 Jul 220 5^{1/2} 297 ^{1/4}

44^{1/2} 40 Oct 58 6 10 ^{1/2}

44^{1/2} 45 Apr 3050 ^{7/8} 100 1^{1/8}
44^{1/2} 45 May 462 1^{3/8} 50 1^{3/8}

44^{1/2} 45 Jul 883 1^{15/16} 147 1^{3/4}

44^{1/2} 45 Oct 367 2^{3/4} 188 2^{1/16}

### A Numerical Example (continued)

*• The Merck option relevant for pricing is the July call*
*with a strike price of X/n = 30 dollars.*

*• Such a call is selling for $15.25.*

*• So XYZ.com’s stock is worth 15.25 × n = 15, 250 dollars.*

*• The entire bond issue is worth*

*B = 44, 500 − 15, 250 = 29, 250*
dollars.

**– Or $975 per bond.**

### A Numerical Example (continued)

*• The XYZ.com bonds are equivalent to a default-free*
*zero-coupon bond with $X par value plus n written*
European puts on Merck at a strike price of $30.

**– By the put-call parity.**^{a}

*• The diﬀerence between B and the price of the*
default-free bond is the value of these puts.

*• The next table shows the total market values of the*
XYZ.com stock and bonds under various debt amounts
*X.*

aRecall p. 228.

Promised payment Current market Current market Current total to bondholders value of bonds value of stock value of firm

*X* *B* *nS* *V*

30,000 29,250.0 15,250.0 44,500

35,000 35,000.0 9,500.0 44,500

40,000 39,000.0 5,500.0 44,500

45,000 42,562.5 1,937.5 44,500

### A Numerical Example (continued)

*• Suppose the promised payment to bondholders is*

$45,000.

*• Then the relevant option is the July call with a strike*
*price of 45, 000/n = 45 dollars.*

*• Since that option is selling for $1*^{15/16}, the market value
*of the XYZ.com stock is (1 + 15/16) × n = 1, 937.5*

dollars.

*• The market value of the stock decreases as the*
debt-to-equity ratio increases.

### A Numerical Example (continued)

*• There are conﬂicts between stockholders and*
bondholders.

*• An option’s terms cannot be changed after issuance.*

*• But a ﬁrm can change its capital structure.*

*• There lies one key diﬀerence between options and*
corporate securities.

**– Parameters such volatility,**^{a} dividend, and strike price
are under partial control of the stockholders or

boards.

aThis is called the asset substitution problem (Myers, 1977).

### A Numerical Example (continued)

*• Suppose XYZ.com issues 15 more bonds with the same*
terms to buy back stock.

*• The total debt is now X = 45,000 dollars.*

*• The table on p. 385 says the total market value of the*
bonds should be $42,562.5.

*• The new bondholders pay*

*42, 562.5 × (15/45) = 14, 187.5*
dollars.

*• The remaining stock is worth $1,937.5.*

### A Numerical Example (continued)

*• The stockholders therefore gain*

*14, 187.5 + 1, 937.5 − 15, 250 = 875*
dollars.

*• The original bondholders lose an equal amount,*
*29, 250 −* 30

45 *× 42, 562.5 = 875.*

**– This is called claim dilution.**^{a}

aFama & M. H. Miller (1972).

### A Numerical Example (continued)

*• Suppose the stockholders sell (1/3) × n Merck shares to*
fund a $14,833.3 cash dividend.

*• The stockholders now have $14,833.3 in cash plus a call*
*on (2/3) × n Merck shares.*

*• The strike price remains X = 30, 000.*

*• This is equivalent to owning 2/3 of a call on n Merck*
shares with a strike price of $45,000.

*• n such calls are worth $1,937.5 (p. 385).*

*• So the total market value of the XYZ.com stock is*
*(2/3) × 1, 937.5 = 1, 291.67 dollars.*

### A Numerical Example (concluded)

*• The market value of the XYZ.com bonds is hence*
*(2/3) × n × 44.5 − 1, 291.67 = 28, 375*
dollars.

*• Hence the stockholders gain*

*14, 833.3 + 1, 291.67 − 15, 250 ≈ 875*
dollars.

*• The bondholders watch their value drop from $29,250 to*

$28,375, a loss of $875.

### Further Topics

*• Other examples:*^{a}

**– Stock as compound call when company issues coupon**
bonds.

**– Subordinated debts as bull call spreads.**

**– Warrants as calls.**

**– Callable bonds as American calls with 2 strike prices.**

**– Convertible bonds.**

**– Bonds with safety covenants as barrier options.**

aCox & Rubinstein (1985); Geske (1977).

### Further Topics (concluded)

*• Securities issued by ﬁrms with a complex capital*
structure must be solved by trees.^{a}

aDai (B82506025, R86526008, D8852600), Lyuu, & C. Wang (F95922018) (2010).

### Distance to Default (DTD)

^{a}

*• Let μ be the total value V ’s rate of expected return.*

*• From Eq. (54), on p. 378, the probability of default τ*
years from now equals

*N (−DTD),*
where

DTD =^{Δ} *ln(V /X) + (μ − σ*^{2}*/2)τ*
*σ√*

*τ* *.*

*• V/X is called the leverage ratio.*

aMerton (1974).