The haunted house or how to pay for being frightened!
In the 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 assets (contingency value rights, warrants and stock options) can be analysed as options or as the combination of an option and a less risky asset.1
Why do we place a chapter on options here, right in the middle of the financial securities a company can use to raise financing?
Some securities are de facto financial options. For example, we will show that a warrant can be compared to a call option.
Some securities have embedded options, i.e. options incorporated into the main contract. As we will see in the next chapter, a convertible bond can be seen as a combination of a conventional bond and an option.
Some securities can be usefully interpreted with the options framework. For example, equity capital can be conceptually analysed as a call option on the value of the firm, while a long-term loan is the sum of several short-term debts and an option on future trends in the yield curve.
We will also examine how options theory can be applied to ...