WFU Law School
Law & Valuation
4.3 Stock Valuation Basics

4.4 Options - Characteristics and Valuation

The 1990s were a decade of revolutionary change in financial markets. Perhaps the most significant change was the emergence of "derivatives," securities whose value is derived from the value of an underlying asset such as a stock, bond, or commodity. While some derivatives (like options and forward contracts) have been around for quite some time, the 1990s brought a wave of financial innovation and growth in the use of derivatives. Today, the derivatives markets have become the largest, financial or otherwise, in the world.

Derivatives are used in one or more of the following three ways:

  • Hedging--where risks are reduced without as significant an impact on returns.
  • Speculating--where risks are increased in an attempt to enhance returns.
  • Capitalizing on arbitrage opportunities--where an investor attempts to capture a riskless profit.

Whatever their function, all financial derivatives share fundamental characteristics. They are are financial instruments whose value is based on the market value of an underlying asset such as a stock, bond, or commodity. Examples include options, futures contracts, and forward contracts.

This section focuses on options, given their relative simplicity and importance in a variety of legal contexts. We first look at the basic terminology and operation of options. Then we introduced the Black Scholes Option Pricing Model, a sophisticated and important model for valuing options. Next we explore some applications of option valuation and option theory. Finally, we examine some other derivatives.

4.4.1 - Option fundamentals

Let's play a game. I will give you $5 if you flip a coin and it comes up heads twice. If not, I pay nothing. To play my game, you must pay me $1.00 for each flip. We can play as many times as you'd like. Are you interested? (More 4.4.1>>)

4.4.2 - Basic option valuation

Surprisingly, but like most of modern financial theory, the systematic valuation of options is a relatively new field. In the 1960s, options only existed on a few of the bigger stocks. Prices were largely set by negotiations, and rules of thumb prevailed. Meanwhile, the topic of pricing options was heating up the offices of the country's leading economic academicians. (More 4.4.2>>)

4.4.3 - Option applications

Perhaps the area where stock options are most pervasive is executive compensation. Frequently, companies will award key executives or board members lucrative stock options in addition to their base compensation. Another area is the use of options to lock-up the bidding for a company in a takeover. (More 4.4.3>>)

4.4.4 - Other derivatives

Options are derivatives in the sense that their value is derived from an underlying security. As the term is commonly used, derivatives refer to instruments also include negotiated contracts between two persons called counterparties. (More 4.4.4>>)

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4.3 Stock Valuation Basics

©2003 Professor Alan R. Palmiter

This page was last updated on: March 30, 2004