Question

Explain the rationale behind the idea that equity is a call option on a firm's assets. In other words, explain why equity ownership of a firm is equivalent to owning a call option on the firm’s assets. Next, explain what it would mean for shareholders to allow this call option to expire, and under what circumstances shareholders would do so.

Answer 1

In Equity ownership, owner buy the shares (equity) at X price and hold them as per his/her view. Increase in share price of that particular share give notional profit (if not booked) to the owner and decrease in share price will be notional loss (if not booked). Now talking about the call option, A call option is an option contract in which buyer has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) until its expiration. Call option has same specification as equity but options trades at premium and with change in price and time premium also change. If one buys call option and price of future of that option increase then premium also increase and theta (change in value of premium with time) decrease or in other words, closer we move towards expiry, lesser the premium. At expiry premium will be zero. So equity ownership is indirectly equal to owning a call option as in both cases profit/loss is directly proportion to price movement of the security.

If shareholder allow call option to expire and option is out of money (strike price is more than spot price) or at the money (strike price equals to spot price) then value of the option will be zero at expiry and owner of the call option will face losses equals to premium paid. And if call option is In the money (strike price is less then spot price) then profit will be (Strike price - Spot price - Premium paid).