This is the first of four chapters dealing with options. Options are important innovations of modern finance and an understanding of the theory and practice of option valuation and applications will help the financial manager do his or her job better. This chapter gives you a detailed introduction to the two basic options, calls and puts. The chapter helps you understand the working of options through position diagrams which shows the pay-off of different positions in calls, puts, or shares held by an investor. Although the chapter focuses primarily on exchange-traded options on stocks the concepts and valuation principles are general and can be extended to options on different assets and liabilities. While formal valuation of options is left to the next chapter, this chapter gives you an intuitive description of what determines an option's value. Chapter 22 deals with the applications of option theory to real options and chapter 23 describes warrants and convertible bonds, which are examples of options commonly used in corporate financing.

Most stock options are traded in exchanges and are not controlled by the corporations on whose stocks these options are based. These options do not directly affect the companies or their balance sheets. However, a financial manager needs to understand options and their valuation, as these are very useful in managing and understanding risk associated with many management decisions. Nearly all corporate securities are options themselves or have some kind of options embedded in them. Financial managers will also have to deal with options related to commodities, exchange rates, and interest rates. Corporate bonds often have call features and other options attached to them. Options are also part of many capital budgeting decisions, which involve embedded options to expand, abandon, or, in other ways, modify the project cash flows. A clear understanding of the principles of option valuation will help the manager understand the trade-off involved and arrive at the optimal decision.