This chapter introduces the wide world of option valuation and some of its more important implications for corporate finance. In it, we saw that:
The put-call parity (PCP) condition tells us that among a call option, a put option, a risk-free investment like a T-bill, and an underlying asset such as shares of stock, we can replicate any one using the other three.
The Black-Scholes Option Pricing Model (OPM) lets us explicitly value call options given values for the five relevant inputs, which are the price of the underlying asset, the strike price, the time to expiration, the risk-free rate, and the standard deviation of the return on the underlying asset.
The effect of changing the inputs into the Black-Scholes OPM varies. Some have positive effects, some negative. The magnitude also varies; relatively small changes in the risk-free rate don't have much of an effect, but changes in the standard deviation can have a very large effect. These various effects are known as the "greeks" because of the Greek (and quasi-Greek) letters used to identify them.
The equity in a leveraged corporation can be viewed as a call option on the assets of the firm. This gives the stockholders a strong incentive to increase the volatility of the return on the firm's assets, even if that means accepting projects with lower NPVs.
