Chapter 23 Options
The haunted house, or how to pay for being frightened!
In previous chapters, we saw that when calculating net present value, the required rate of return includes a risk premium that is added to the time value of money. The study of options is useful from a purely financial point of view, as it highlights the notion of remuneration of risk.
True, options are more complex than shares or bonds. Moreover, in their daily use they have more to do with financial management than finance. However, we will see that many financial products (warrants, stock options) can be analysed as options or as the combination of an option and a less risky asset. Have some fun by discovering the options hidden in any financial product!
A convertible bond can be seen as a combination of a conventional bond and an option. An undrawn revolving credit facility can be analysed as an option on a loan.
We will also examine how options theory can be applied to major financial strategy decisions within a company.
The purpose of this chapter is not to make you a wizard in manipulating options or to teach you the techniques of speculation or hedging with options, but merely to show you how they work in practice.
Section 23.1 Definition and theoretical foundation of options
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