8.1ADescription of Options and Options Markets

There are two basic types of options, call options and put options. The next subsection

elaborates on an additional important classification of options.

European and American Options

•	AEuropeancall (put) optionis the right to buy (sell) a unit of the underlyingasset at the strike price, at a specific point in time,the expiration date.
•	An Americancall (put) optionis the right to buy (sell) a unit of the underlying asset at any time on or beforethe expiration date of the option.

1

Hedging is discussed in Chapter 22.

²Callable bonds give the corporation the right to redeem the outstanding bonds before maturity by

paying a premium to bondholders. Therefore, it is an option which the firm can choose to exercise by

“calling” the bonds. Typically, this will occur when interest rates are low. See Chapter 2.

Grinblatt534Titman: Financial	II. Valuing Financial Assets	8. Options	© The McGraw534Hill
Markets and Corporate			Companies, 2002
Strategy, Second Edition

Chapter 8

Options

259

Most of the options that trade on organized exchanges are American options. For

example, the Chicago Board Options Exchange (CBOE) trades American options,

primarily on stocks and stock indexes like the S&P100 and the S&P500. European

options traded from the mid-1980s through 1992 on the American Stock Exchange and

are often traded in the over-the-counter market as well. The American Stock Exchange

reintroduced them in the late 1990s.

European options are easier to value than American options because the analyst

need only be concerned about their value at one future date. However, in some cir-

cumstances, which will be discussed shortly, both European and American options have

the same value. Because of their relative simplicity and because the understanding of

European option valuation is often the springboard to understanding the process of valu-

ing the more popular American options, this chapter devotes more space to the valua-

tion of European options than to American options.

The Four Features of Options

Four features characterize a simple option, the offer of the right to buy (call) or the

right to sell (put):

1.An underlying risky asset that determines the option’s value at some future

date.³

2.Astrike price.

3.An exercise commencement date, before which the option cannot be

exercised.

4.An expiration date beyond which the option can no longer be exercised.

Because European options can be exercised only on their expiration dates, their

commencement and expiration dates are the same. American options, which can be

exercised at any time on or before their expiration dates, have commencement dates

that coincide with their dates of initial issuance.⁴