CH8 - Options & Real World Options

Question 1

Types

Answer 1

American/Traded Options: Standardised Option contracts, can be exercised on any day up until its expiry

European/OTC Option: Tailor-made option, sold by a bank, can only be exercised on the last day of an option.

Question 2

Notes

Answer 2

1. The higher the time to expiry, the more chance of profit, increasing option value.
2. The greater the volatility the better, as there is no downside apart from the issue costs.
3. The higher the interest rate, the lower the PV of the exercise price. This reduces the cost of exercising and adds to the value of the current call option value.
4. Also, since money left in the bank will generate a higher return, the call option is valued higher with higher interest rates.

Question 3

Real Options Theory

Answer 3

Real Options Theory = attempts to value flexibility by developing financial options pricing as a general model.

Also attempts to solve the issue that conventional IA methods typically undervalue flexibility within projects of high uncertainty.

For example:
High uncertainty within NPV will simply have a higher discount rate.

Question 4

Types of ‘Real’ Options

Answer 4

Options to delay/defer e.g. drug patents

Options to switch/redeploy - Flexible Manufacturing systems, also gearing: choosing higher variable costs so it’s more beneficial if plant doesn’t have to operate

Options to expand/follow-on: increase depending on market conditions

Options to abandon

Question 5

Black Scholes Modelling Real Options:

Answer 5

Exercise price/strike price – replace with capital investment required/salvage value

Value of the underlying asset (Share price) – PV of future cash flows/opportunity cost excluding initial investment (cash flows at Tn after)

Time to expiry – time of replacement e.g. after 2 years or 1 year

Volatility – industry sector risk

Risk-free rate – many argue a higher rate for extra risks when replacing share price with PV of future cash flows.

Take Initial Investment as a minus plus the Option price.