Corporate Finance Notes

4-3-08
Options, Futures, and Derivatives
Derivative
• Something that obtains its value from something else
• Financially engineered commodities
• Stripped down combinations of anything you can think of

Options, futures, forwards – oldest forms of derivatives

It’s difficult to regulate new derivatives
Very risky

Options
• A contract that allows you to buy or sell a specified financial asset at a specified
strike price at a specified time and place
o Price = option premium
o Normally sold in 100 share lots
• Come in 2 forms
o Call – option to call in or demand the asset at a specific price over a
specified time period
 Typically a bullish action
 Only want to act on an option when the share price is above the
strike price listed on the option
o Put – option to sell shares at a specified price over a specified time
 Bearish on the prices
 Only sell when the market price is lower than the strike price listed
on the put

Basic option properties:

1. The buyer of the call/put always has the flexibility
2. The buyer’s maximum exposure is equal to the premium price of the option, while
the seller’s exposure is significant and depends on the market’s fluctuation
3. Options are a zero sum game – no total gains. Every gain is a loss for someone
else.
4. A necessary condition for the transaction of an option to take place is that the
buyer’s and seller’s expectations about the future price of the underlying asset
must differ – pro quo, the zero sum game
 5. Hence, institutional differences between buyers and sellers usually arise, sellers
have more information and more experience – they are the ones taking on the
higher risk and thus would have to be fairly well informed to continue operations

Ps = strike price
q = option premium
Pt = price of underlying asset at time t
T = terminal time for the option

Calls

πt = Pt – Ps – q0
Profit is the price of the stock at time P less the strike price and the option cost

q = sunk cost, need not be considered when deciding when to exercise the option

Also, at issuance,
πt = P0 – Ps – q0 ≤ 0
Thus,
P 0 ≤ P s + q0
Since profit is current price minus strike price minus the cost of the option, the price at
the issuance of the option, P0, cannot be greater than the strike price plus the option price
or there would be the profit opportunity for infinite arbitrage

Buyers of Calls Sellers of Calls

Max Profit ∞ q0
Max Loss -q0 -∞

Payoff map for calls

 Price

Path of stock price

Π
Ps + q0

P0 = Ps

No π opportunity

A buyer of a call or an option needs to monitor the stock price daily in order to know if
it’s a good time to cash in the option.
Sellers do not. They have no further decisions to make.

It’s very important at initial investment to:

• Set a maximum price at which you will sell no matter what the prospects look like
• Set a minimum price at which you will ditch and sell the option
• You could be right and have a great increase in the price of the stock but then lose
your gains because you greedily wait too long for a greater increase

Sellers have two real choices when issuing options

• They can cover their position by going long in the stock and buy more of the
stock at issuance of the options
• Or, they can go naked and hold no shares of the optioned stock

Ex-post value of calls

V = ex post value
 V V - buyer

45º

Ps P

V - seller

Puts

πt = Ps – Pt – q0
Profit for the buyer of a put is the strike price less the price of the stock at time t less the
price of the option

Also,
πt = Ps – P0 – q0 ≤ 0
Thus,
P0 ≤ Ps + q
Again, similar to the case with calls, the market price of the stock at issuance of the
option must be lower than the strike price of the option plus the cost of the option or else
there would be a perfect arbitrage opportunity for infinite profit

Buyers of puts Sellers of puts

Max Profit Ps – q0 q0
Max Loss -q0 - Ps + q0
 Payoff map for calls

Price

Path A
No π opportunity
P0 = Ps

P s - q0

Π
Path B

Ex post value of puts

V = ex-post value of puts

V - buyer

Ps P

V - seller
Expected profit functions for buyers/sellers of calls
Ph = high price outcome
Pl = low price outcome

Π – buyer:
• πh = (Ph – Ps) – q0
• πh = -q0

a = buyer’s probability that Ph will prevail

• π = (a)(πh) + (1-a)(πl)

π = a(Ph – Ps) – q0
The likely profit for the buyer of a call would be the probability of the high price
outcome times the difference between that outcome and the strike price, less the price of
the option

Π – seller:
• πh = q0 + (Ps – Ph)
• π h = q0

b = seller’s probability that Ph will prevail

• π = (b)(πh) + (1-b)(πl)
• π = (b)(q0 + Ps – Ph) + (1-b)(q0)

π = q0 + (b)(Ps – Ph)
The probable profit for the seller is equal to the price of the option plus the probability of
the high outcome times the difference between the strike price and the high price.

Requirements for buyer and seller:

• Buyer: π = (a)(Ph – Ps) – q0 > 0
• Seller: π = q0 + (b)(Ps – Ph) > 0

Must-be case for the seller:

• 0 > (b)(Ph – Ps) – q0
• This makes sense because it shows that the seller’s expected probability that the
high price will prevail, b, times the difference in the high price and the strike
price, an amount that erodes their profits (they agreed to sell the stock at the strike
 price so any difference between that and the market price is something they have
to pay), less their payoff, the selling price of the option, must stay below zero or
they will never offer the option.

Must-be case for the buyer:

• (a)(Ph – Ps) – q0 > 0
• This is simply the profit formula for the buyer, so, of course they expect that it
will be greater than 0.

Together these show that:

• (a)(Ph – Ps) – q0 > 0 > (b)(Ph – Ps) – q0
• Or simply, (a)(Ph – Ps) – q0 > (b)(Ph – Ps) – q0
• This relationship shows the necessary difference in expectations between the
buyer and seller of an option in order for the transaction to take place. The buyer
must expect a greater probability that the high price will prevail. This also
highlights the zero-sum game nature of options. Adding the two sides of this
equation together comes to zero, a complete wash.
• This equality can even be taken down to a more condensed level by simplifying
to: a > b. This most clearly states the necessary relationship between the buyer’s
and seller’s expectations in order for the transaction to take place – that the buyer
must expect a higher price more than the seller.

4-8-08
Techniques for using options other than trading them:
• Hedging
• Insurance

Protective put:
• Used if you’re long in an asset – holding it for a long-term profit
• Wise if you’re substantially invested in the asset
PV
π

P0 + q

P0
π
No π opportunity

P0 = Ps
P

(PV = portfolio value, P = price of stock)

To insure against possibly losses you buy a put at the same price as your current asset –
forms a protective floor on your losses such that they can only be equal to the price of the
options instead of an unspecified decline in the stock price.

The Straddle:
• Used when you expect significant volatility
PV Call pay-off function

π
P0 = Ps

PL PH
P

qc + qv
No π opportunity

• Buy calls and puts for both ends of the volatility

• Cost = qc + qv
• Not holding the asset
• Straddle compresses the volatility of the assets its being operated on: people
exploit the option and reduce the volatility by arbitrage
o Hard to find patterns that are exploitable

Pyramid:
• Expect little volatility
o Short term
• Choose a lower bound and an upper bound for P such that P0 – PL = PH – P0
o P0 is between PL and PH
o 2P0 = PL + PH
PV

buy a call #1
buy a call #2

P0
PL PH
P

sell 2 calls

Cost = qL + qH – 2q0

Payoff functions

Price State Buy Call Sell 2 Calls Buy Call Pay-off

(Ps = PL) (Ps = P0) (Ps = PH)
Pt ≤ PL 0 0 0 0

PL < Pt ≤ P0 (Pt – PL) 0 0 (Pt – PL)

P0 < Pt < PH (Pt – PL) -2(Pt – P0) 0 (Pt – PL) -

2(Pt – P0)
Pt ≥ PH (Pt – PL) -2(Pt – P0) (Pt – PH) (Pt – PL) -
2(Pt – P0) +
(Pt – PH)

Profit is equal to whatever the payoff is because the cost is 0

PV

buy a call #1
buy a call #2
π

C
P0
No π opportunity PL PH No π opportunity P

sell 2 calls

This maneuver would have the effect of increasing the volatility of the stock because it
exploits a steady stock price. Thus, increased use of this strategy would push up the
volatility of the stock.

4-10-08
Options and Option Pricing
• Extremely difficult and complicated
• Always have a terminal value of 0 if not exercised – if it is exercised the value of
the option falls on the value function of the option

Call option prices: qt

• A function of various factors: qt = q(Pt, Ps, T, r, σ)
o Pt ~ price of the option’s base asset at time t: a higher Pt increases value
o Ps ~ strike price of the option: higher Ps decreases value
o T ~ terminal expiration date of option: higher T increases value
o r ~ rate of interest: higher r increases value
o σ ~ variance in Pt: higher σ increases value

π = Pt – Ps – q0 (Pt > Ps)

π = -q0 (Pt < Ps)

q0 is a sunk cost and thus irrelevant to option pricing

How each factor influences option pricing:

• Pt – quite simply, the higher the value of the underlying asset the higher the value
of the option
• Ps – The higher the strike price then the less value there is to the option because a
higher rise in the stock price is necessary than if the strike price were lower
• T – The longer the time allowed for the price of the asset to rise/fluctuate the
more likely it is that the strike price will be reached, hence increasing the value of
the option
• r – Interest rates influence on option pricing is a little more complicated
o Options are essentially an installment plan purchase with uncertainty
added in. The uncertainty doesn’t play a role in our analysis of interest
rates’ effects on option prices so we’ll disregard the uncertainty in options.
You have a beginning down payment, q0, the price of the option, and then
a final payment to cash it in of the strike price (remember, no uncertainty,
so the strike price will be reached). The present value of that final
payment (a payment you will have to pay to cash in your option) would be
equal to the present value of the strike price, which depends on r: PV =
Ps(1 + r)-T. As we can see, then, the higher r is, the lower the PV of that
final payment would be. Thus, as the PV of that cost decreases due to
increases in r, the value of the option increases.
• σ – As the variance of the underlying stock price increases the likelihood that the
stock price will reach the strike price at some point increases as well, thus raising
the value of the option.

Trading range for qt: qL ≤ qt ≤ qH

• Lower bound:
o qL = 0 (Pt ≤ Ps)
o qL = Value function (Pt > Ps)
• Upper bound:
o Set Ps/q0 = 0 (absolute highest possible value for the option – no strike
price to be paid)
o Thus, qH = q = Pt
 q Upper bound of V

Path of V

Lower bound of V (Pt - Ps)

Price where
you exercise
the option

Ps Pt * Pt

qt*( Pt*) = Pt* - Ps(1 + r)-T

Question: Is the curve above a representation of the equation qt*( Pt*) = Pt* - Ps(1 + r)-T ?
If so, what causes the difference between the two lines to approach zero?

Black Shoals Option Pricing Model

Pricing the option:

• Find a strategy equivalent to the option strategy that goes long in the asset, with
some leverage, that will yield the same payoff.
• We assume a high-bound and low-bound and analyze their pay-offs/costs that
equivocate the option’s pay-offs/costs
• Then, we solve in order to equivocate the costs between the two such that their
yields are the same

Payoffs
Strategy CF0 PL PH
A – Purchase ‘x’ shares of -xq 0 x(PH – Ps)
option ‘o’
B – two parts
1.) Purchase ‘s’ shares of 1.) -sP0 1.) sPL 1.) sPH
stock 2.) -sPL 2.) -sPL
2.) Borrow PV of PL 2.) + sPL(1 + r)-T
payoff
Net payoffs/CF’s (B) s(PL(1 + r)-T – P0) 0 s(PH – PL)

Set the two payoffs equal [s(PH – PL) = x(PH – Ps)] in order to find the number of shares
you would have to buy to make the payoffs equal.

s = x(PH – Ps)/(PH – PL): this gives the number of shares that you would have to a.) borrow
the PV of the low outcome and b.) purchase in order to equal x options.

Then, we can see the beginning costs:

• -xq for the options
• s(PL(1 + r)-T – P0) for the shares

Since the number of shares that you would have to buy, s, is equal to x(PH – PL)/(PH – PL),
we can see that [x(PH – Ps)/(PH – PL)]*[(PL(1 + r)-T – P0)] would equal the total cost of
purchasing the shares.

Now, since we want to make the profits between these two ventures completely equal, we
need to equivocate there costs. In order to do so we can set the cost of the options, with
unknown option price q, equal to the costs solved above in order to be in terms of the # of
option shares.

-xq = x(PH – Ps)/(PH – PL)]*[(PL(1 + r)-T – P0)

Then, we can solve for q finding,

q = (P0 – PL(1 + r)-T)(PH – Ps)/(PH – PL)

This gives us the price of the options. This functions because we’ve set the payoffs and
the costs of these two strategies equal. We know for sure the costs and payoffs of buying
the shares and borrowing the PV of the PL outcome, so we can solve for the number of
shares in terms of the number of options by setting the two equal. Then, since we know
the number of shares necessary in terms of the number of options, we can set the
beginning costs equal so that the cost of the options will equal the cost of the shares.
This gives us a viable option price.
4-14-08
Firms are exposed to two types of risk:
• Macro risks
o Can be dealt with/anticipated: such as industry risk
• Firm specific risk
o Can be diversified away by shareholders

Essentially, the question is why do firms engage in risk management activities when
shareholders could just as easily do so themselves? Firms have no reason to buy
insurance in perfectly efficient markets where shareholders know all the info about every
firm’s risk and opportunity. They can then just simply diversify and insure themselves.
The question is then, why do firms spend time diversifying risk that they aren’t paid to
cover? The reason comes from the fact that we don’t have perfectly efficient capital
markets and large stakeholders in firms is a necessity to help control the principal agent
problem. Thus, these large holders have not diversified themselves, but they haven’t
done so because they are helping to control the efficiency lessening principal agent
problem.

Firms, then, must examine the risks that they’re being paid to bear and shed those that
they are not being paid to carry.

5-step procedure to analyze risk position:

1.) Identify where the risk exposure is and what is the worst that could happen.
2.) Is the company being paid to carry this risk particular risk?
3.) Due diligence: can we lower this risk with our own actions? Explore in house
options to reduce risk. Then, when you go to purchase outside insurance it will cost less
because you have minimized your exposure as best you can in house.
4.) Can the company purchase insurance to cover losses? Important to then take into
account moral hazard. Risk pooling is what makes insurance function. Also shows why
some things aren’t insured because there isn’t a large enough group of people seeking
insurance for it.
5.) If there are not enough people to pool together such that insurance would be offered
for your particular exposure is there some other option that you could explore to cover
your position? Lower risk lowers your beta and increases the value to stock holders.

Options:
• Purchase a call to insure the price of an input.
• Purchase a put to protect revenue

If a firm is able to remove these risks it can concentrate on those it is supposed to bear.

Futures – openly exchanged and traded, all identical contracts, trade like a commodity
Forwards – specifically tailored contracts for a certain party
Futures:
• Futures prices can convey information depending on what the future is for
• Are contracts with specific dates/outcomes

Mechanics of futures trading:

• Highly standardized
• Price is fixed today but payment does not come until termination
• Must put up some margin money when the contract is first signed
• Sold with “marked to market”
o Every day between now and the closing date the future will be adjusted for
any changes in market value. You will either openly and physically
receive a payment for the gain of your future or have to front more money
on the loss.
• The underlying commodity of a future does have a spot price.
o As the terminal time of the contract approaches the contract price
converges on the spot price

4-17-08
Futures can be used to hedge against risk in interest changes, exchange rate risk, and
revenue risks

Swaps (interest rate/currency)

• Cost is the concern ~ a firm could have issued variable bonds and be worried
about the possible fluctuations in interest payments and want to solidify this risk
that its not being paid to bear
o The risk is a variable string of payments
o The objective is to convert the variable stream into a fixed stream without
incurring the massive transactions cost associated with converting the debt
into some other form of financing
o The strategy – purchase a variable stream of interest payments while
issuing a fixed income stream as an obligation to pay for the just
purchased variable stream. This leaves you with the obligation to pay a
steady stream and gives you a variable income to match the other variable
cost. Otherwise known as the notional principle.
• Revenue is the concern ~ a portfolio manager could be holding a portfolio of
long-term fixed coupon bonds that would have significant capital gains losses if
the interest rate rises
o Risk – varying portfolio value
o Objective – minimize capital gains risk
 o Strategy – enter a swap in which you buy a variable stream on the basis of
the notional principal while simultaneously selling a fixed income stream
of payments. Buy the stream such that any increases in the interest rate
that decreases the portfolio value will provide an insurance income of
equal amount.
• Currency swap ~ company with overseas operations may be able to raise capital
for expansion in another country at home giving the firm the responsibility to
repay the financing with the home currency even though ops will be in the foreign
currency.
o Risk – currency exchange rate could fluctuate and erode an otherwise
profitable venture abroad
o Objective – remove exchange rate risk by swapping dollars for foreign
exchange without being subject to exchange rate risk
o Strategy – borrow domestically, buy foreign currency to make overseas
investment: enter swaps such that you agree to make a series of foreign
exchange payments for a fixed stream of dollar payments in exchange.

Mergers and Acquisitions

#1 question: Are we doing something for the shareholders that they can’t do for
themselves?
• Hard to overcome
• Stockholders can make whatever mix of stocks that they like

WA ~ current wealth generated by the acquiring company

WT ~ current wealth generated by the target company
W* ~ wealth generated by the combined firms
WMT ~ maximum current wealth possible of target firm

Necessary condition to justify the merger of two firms,

W* > WA + WT

To decide the value of a potential merger or acquisition we would need to determine

what, if anything, could contribute to/influence the W* (opposed to simply the WA and the
WT) such that PVGO* > PVGOA + PVGOT?

Classic motives for M&A:

1.) Negative wealth at the target firm: WT < 0

a. WT = BM + EM - AM
b. W* = WA + AM – BM - EM
 i. AM – BM – EM > 0 when wealth is negative
ii. W* > WA + WT
c. Good acquisition opportunity
2.) Replace existing management because maximum potential wealth of the target
firm (WMT) is greater than current wealth (WT).
a. W* = WA + WMT > WT + WA
b. Difficult to determine WMT especially if you’re unfamiliar with the
industry. It’s hard to analyze the maximum possible wealth without being
personally familiar with the business.
i. Analytical errors are common
ii. Even more common are egotistical errors in which management
scoffs another company’s management and claims that they would
be able to run things better
c. However, shareholders can do neither of the preceding analysis for
themselves.
3.) Economies of Scale
a. Long run
b. Cost decreases with greater quantity
c. Horizontal in nature
i. Horizontal – two firms in the same industry
ii. Vertical – a firm in your chain of operation either above or below
you
iii. Conglomerate – different industries entirely
d. New levels of profitability for both firms:
i. W* = W*A + W*T > WA + WT
4.) Mergers of vertical integration
a. More ambiguous than horizontal mergers – horizontal mergers have to
prove themselves to be worth going before the FTC but vertical don’t
b. Firms are more integrated nowadays so that the collusion and connection
between firms in an operation chain it greater. Thus it is harder to find
and exploit wealth opportunities that would come through making these
firms one.
5.) Economies of scope
a. Complimentary products/assets
b. One of the most potentially profitable merger reasons
c. More likely to find W* = W*A + W*T > WA + WT
6.) Mergers to use surplus cash (BAD)
a. IF a firm has a cash surplus with all positive NPV projects already funded
it has no reason to purchase another firm simply to use cash
b. Principle agent problem really manifests itself here – management desires
to grow the firm and thus their salaries, and also, having cash on the
balance sheet makes the firm look like a good takeover target, threatening
the job security of management.
7.) Diversification (BAD)
 a. There is no reason whatsoever for a firm to try to invest in M&A for the
purpose of diversifying itself. This violates the cardinal rule of whether
it’s something shareholders can do for themselves or not.
8.) Bootstrapping: Ponzi scheme
a. The general principle behind bootstrapping is that (P/E)A > (P/E)T: what
the acquiring firm will do is show its massively impressive P/E ratio and
then issue shares to pay for acquiring the new firm. The Ponzi scheme
then follows with the newly acquired firm’s earnings to its P/E ratio and
then uses the newly boosted (but yet to be tested) P/E ratio to issue its now
more highly valued shares to purchase another firm. The original firm
will continue this process to continue boosting its P/E ratio etcetera,
etcetera. This scheme is unsustainable and will collapse the minute the
original firm ceases its acquiring run.

Methods for gaining control of other firms

1.) Proxy contest
a. Rare because it rarely succeeds
b. Have to solicit shareholders’ votes to gain control
i. Green mail – a group will gather a great enough percentage of
control to harass management until management pays them off
c. Regulations make a proxy contest difficult because FTC rules require a
shareholder to register at 5%.
i. Because of this someone gathering momentum for a proxy contest
or green mail will usually purchase 4.99% of a firm and then buy
options for another 15-20% of the firm.
2.) Mergers and Acquisitions: two firms come together to make a single firm –
usually similar size
a. Sometimes reverses when minnows swallow whales, usually with junk
bonds
b. Mergers
i. Usually friendly
ii. Usually organized by/originated from investment bankers – they
see the opportunities for economies of scale
c. Acquisitions – when a larger firm buys a smaller
i. Sometimes reverses when small firms use junk bonds to purchase
larger firms
ii. Two types of acquisitions
1. Tender offer – go for the shares of the target firm: could be
either friendly or hostile
a. Friendly tender: Acquiring firm approaches
management and makes a friendly offer for the
target firm.
i. In this case a friendly conclusion could be
reached and the current management would
 support the acquisition to the
shareholders/board.
b. Hostile tender
i. Acquiring firm secretly buys the other firms
shares whether the target firm likes it or not.
1. Often arrive with winner’s curse –
end up paying too much for the
target.
2. Greater risk in hostile takeovers
2. Buying target’s assets
a. This method benefits from the fact that if you buy
the firm legally through shares you also incur the
firm’s liabilities
b. However, if you buy only the assets you leave the
liabilities with the still legally intact firm.
c. What’s left of the firm and its liabilities will be
distributed to the stockholders
3.) Leveraged buyout – buying a publicly held firm and taking it private
a. Target firm is paid for in cash
b. LBO – leveraged buyout
i. Junk bonds issued to finance buyout
c. MBO – management buyout
i. Usually a bad sign that the stock is undervalued and that there is
more value in the firm than management has been letting on
4.) Divestitures – subsidiaries that firms decide to spin off
a. Spin-off must be losing money to be worthy of dropping
b. Acquiring firm must have significant and tangible advantage over target
firm in using the subsidiary

Defensive Strategies

• Poison Pill
o Something in the charter of a firm that gives the right of the target firm to
issue shares to stockholders at an attractive low price thus complicating
the merger
• White knight
o Savior firm with whom a possible target has a previous arrangement with
a friendly firm that can come in and purchase the target instead of the
hostile firm
• Shark repellant
o In the event that someone proposes a merger it is in the charter that it
would need more than a super majority to pass the merger

Merger Valuation Techniques

We examine the possibility as if it would be financed with either all cash or all equity.
Debt functions like cash, a seller wouldn’t distinguish between the two.

100% Cash purchase:

Two questions:
• What is the source of the EVA offered by this merger/acquisition – the economic
gain must be specifically enumerated?
• Do the terms of this action make sense for our shareholders?

1.) Economic gain – present value of the change in free cash flows (PVΔFCF) from
merger
a. Examine economies of scale, scope, and vertical gains for the source of
these EG’s
b. Specifically identify the source/amount of the gains
2.) Cost of cash merger
a. C = cash - EMT: this is incremental cost and shows a premium on the
3.) NPV from the merger = EG – cash + EMT = W* - WA – WT > 0
a. Can use this EG to set a reservation price at which you will stop bidding

100% Equity purchase

1.) Economic gain (EVA):

a. EG = PVΔFCF
2.) Cost:
a. The biggest difference in the equity option vs the cash option is the cost.
With the equity option the cost is dependent on the exchange rate between
the two companies and the price of the issuing company’s shares.
b. Number of issued shares = the number of target shares over the exchange
rate
c. C = PA (price of acquirer’s shares) * Shares - EMT
3.) NPV = EG – C = W* - WA – WT > 0

The only significant difference between these two methods is the in the cost side.

Sellers prefer the cash option so they can take it and run.

Buyers prefer the equity option for two reasons:

1.) It gives the seller an incentive to see that the merger is successful
2.) If the merger fails, the price falls because the value of the shares fall

If sellers will accept nothing other than cash that could signify a significant contingent
liability that they haven’t disclosed.
Divide the new NPV by the # of shares to give you the incremental change in share price.

Social implications of M&A activity:

• Wealth transfers
o Junk bonds
o Tax shields
o Bondholders/price changes
• Efficiency gains
o Reallocation of resources
o More efficient use of FCF’s

Larges costs associated with mergers are dead weight loss

Social imp.
• Beneficials
o Reallocation of resources
o Better use of FCF’s
o Forces management to pay attention
• Bads
o Impact on laid-off employees without retraining programs