Corporate finance

(TER2407)
Options: introduction,and pricing,real options

Kalle Ahi
kalle.ahi@gmail.com
21st of October, 2014

Todays plan
0 Introduction to derivatives
I Basic options terminology
II Valuation of options
III Real options

What is a Derivative? (I)

Options

Futures

The value of the

derivative instrument is
DERIVED from the
underlying security

Forwards

Swaps

Underlying instrument such as a commodity, a stock, a stock index, an exchange

rate, a bond, another derivative etc..
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What is a Derivative? (II)

Futures

Forwards

The owner of a future has the OBLIGATION to sell or buy

something in the future at a predetermined price.
The owner of a forward has the OBLIGATION to sell or buy
something in the future at a predetermined price. The
difference to a future contract is that forwards are not
standardized.

Options

The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore more
costly than a futures contract.

Swaps

A swap is an agreement between two parties to exchange a

sequence of cash flows.

Reasons to use derivatives (I)

Derivative markets have attained an overwhelming popularity for a
variety of reasons...
Hedging:

Speculation:

Interest rate volatility

Stock price volatility
Exchange rate volatility
Commodity prices volatility
VOLATILITY

High portion of leverage

Huge returns
EXTREMELY RISKY
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Reasons to use Derivatives (II)

Also derivatives create...
a complete market, defined as a market in which all identifiable payoffs can be
obtained by trading the securities available in the market*.
and market efficiency, characterized by low transaction costs and greater
liquidity.

* Futures, Options and Swaps by R.W. Kolb

Options - basic terminology

Derivatives - Derivative financial instruments or simply derivatives are
instruments whose values derive from the value of one or more
underlying securities (e.g. options, warrants, futures, swaps, etc.)
Option - Gives the holder the right to buy or sell a security at a specified
price during a specified period of time.
Call Option - The right to buy a security at a specified price within a
specified time.
Put Option - The right to sell a security at a specified price within a
specified time.
Option Premium - The price paid for the option, above the price of the
underlying security.
Exercise or strike price - The specified price on an option contract at
which the contract may be exercised, whereby a call option buyer can
buy the underlier or a put option buyer can sell the underlier.
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Options - basic terminology (II)

Intrinsic Value - Difference between the strike price and the stock
price
Time Premium - Value of option above the intrinsic value
Expiration Date - The last date on which the option can be
exercised.
American Option - Can be exercised at any time prior to and
including the expiration date.
European Option - Can be exercised only on the expiration date.
All options usually act like European options because you make
more money if you sell the option before expiration (vs. exercising
it).
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Options - basic terminology (III)

Call option
Put option

Long position
Right to buy asset
Right to sell asset

Short position
Obligation to sell asset
Obligation to buy asset

ThisisaGooglestock(September
2008)examplefromBMA.

Option Value
Call buyer profit assume strike of $430 and option
price of $54.35

Position Value

Long call
Break even

-54.35
430

484.35

Share Price
10

Option Value

Position Value

Put seller profit assume strike of $430 and option

price of $48.55

Break even

Short put

+48.55

381.45 430
Share Price
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Option Value

Whythisstrategycouldbecalleda
masochistsstrategy?

Masochists Strategy?- Long stock and short call

Long Stock

Position Value

Silly Strategy?
Combined value

Short Call
Share Price
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Option Value

Wellusethisexampleinorderto
introducetoyouputcallparity

Protective Put - Long stock and long put

Long Stock

Position Value

Combined strategy

Long Put

Share Price
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Option positions in short (at expiration date)

CALL OPTION

PUT OPTION

Short position

Long position

SHARE

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Alchemy of finance

Lets construct two portfolios:

Portfolio A

a long position in the stock

a long position in the put with exercise price of 430

Portfolio B
a long position in a risk free bond which pays 430 at the time of
maturity and
a long position in a call with exercise price of 430

We can see from the next graph that the payoffs are the same
for both portfolios at maturity date.
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NB!Sincetheportfolioshaveidentical
returnprofilesatthedateofmaturity
theymusthavethesamevalue.
Otherwise,thereexistriskfree
arbitrageopportunities.

Values of two portfolios at maturity

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This is Put-Call-Parity at
the date of maturity
But this relationship should
hold for European options
any time if proper
discounting is used.

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Option Value (II)

The value of an option is bound, on the high end, by the value of the
underlying stock. The lower bound is the value of exercising the option.
In between, the major determinants are exercise price and stock price.
(Value of an option is the highest at C highest time premium)

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Valuation of an option (call)

The option value (premium) is influenced by the following

factors

The price of an underlying asset - the higher the value, the

higher the value of a call option
Strike (or exercise) price higher exercise price lowers the value
of an option
Time to expiration longer period means larger value.
Risk of an asset (measured by standard deviation) higher risk
means a higher value of an option. (your gain is not symmetric)
Risk-free interest rate call option basically allows to postpone
the buy into the future. Higher interest rates make the postponing
more valuable and the call premium is higher
Expected dividends expected dividends lower the value of a call
option (value of the put would be higher ceteris paribus)

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Option Value (conclusion)

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II Option valuation methods

Simple

option valuation method

An intro to binomial model for valuing
options
Black Scholes formula

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Option Valuation Methods

We use an example of Google stock and pick a
day when the stock price was $430.
Also assume that Google call options have an
exercise price of $430
Case 1
Fall by 1/4
Stock price falls to
$322.50

Case 2
Rise by 1/3
Stock price rises to
$573.33

Option value = $0

Option value =
$143.33

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Option Valuation Methods (replication )

Now well try to replicate the option values by constructing a

replicating portfolio (invest into stocks and borrow money)
Assume you buy 4/7 of a Google share and borrow $181.58 from
the bank (assume risk free rate @1.5%).

Theamountthatyouneedtoborrow
fromthebankissimplythepresent
valueofthedifferencebetweenthe
payoffsfrom4/7sharesandthe
option.

Value of Call = 430 x (4/7) 181.58

= $64.13
(PV of the portfolio with above
payoffs)
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Where (4/7) and 181.58 comes from

The amount needed to be borrowed from the bank is simply the

present value of the difference between 4/7 of shares and the

option at possible market price scenarios.

In our case:
Amount borrowed = ((4/7)x322.50 - 0)/1.015 = ((4/7)x573.33-143.33)/1.015 = $181.56.
This loan will be repaid = $181.56 + interest = $184.29
spread of possible option prices
Option Delta
spread of possible share prices
143.33 0
143.33 4

573.33 322.50 250.83 7

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Thestrategyhereisanexamplewhat
banksuseiftheysellcallsandwould
wanttocovertheposition(e.g.They
seekahedge).

Derivation of option delta

Well derive the formula:

Form a portfolio consisting of
one written call (short position): +C (brings in some cash)
buy a fraction of one share of underlying stock (long position): - S

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Example continued

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Binomial Pricing
Present and possible future prices of Google stock assuming that in each
three-month period the price will either rise by 22.6% or fall by 18.4%.
Figures in parentheses show the corresponding values of a six-month call
option with an exercise price of $430.

Binomial Pricing
Now we can construct a leveraged position in delta shares that would
give identical payoffs to the option:

We can now find the leveraged position in delta shares that would give
identical payoffs to the option:

Binomial Pricing
Present and possible future prices of Google stock. Figures in parentheses
show the corresponding values of a six-month call option with an exercise
price of $430.

Option Value:
PV option = PV (.569 shares)- PV($199.58)
=.569 x $430 - $199.58/1.0075 = $46.49 (the last ? mark is found)

Binomial Model
The price of an option, using the Binomial method, is significantly
impacted by the time intervals selected.The Google example
illustrates this fact.

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As there is more subintervals, the distribution of price

changes converges to log-normal distribution

10

Black-Scholes option pricing formula

F. Black and M. Scholes, The Pricing of Options and Corporate Liabilities, Journal of
Political Economy 81 (MayJune 1973)

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*Thatis,N(d)istheprobability
thatanormallydistributedrandom
variablexwillbelessthanorequalto
d.N(d1)intheBlack
Scholesformulaistheoptiondelta.
Thustheformulatellsusthatthe
valueofacallisequaltoan
investmentofN(d1)inthe
commonstocklessborrowingofN(d
2)xPV(EX).

Hereweshouldseeastriking
similaritytothereplicatingportfolio
approachweusedbefore.

Call Option
Example - Google
What is the price of a call option given the following?
P = 430
EX = 430

r = 3%
t = 180 days / 365

d1

= .4068

2
ln( P ) (r v )t

EX

d 1 .1952

N ( d 1 ) .5774
Use statistical tables for N(0;1) tables or in
excel NORMSDIST()

Call Option
Example - Google
What is the price of a call option given the following?
P = 430
EX = 430

r = 3%
t = 180 days / 365

= .4068

d 2 d1 t
d 2 .0925
N (d 2 ) 1 .5368 .4632
Or in excel: =NORMDIST(-0.0925;0;1;TRUE)

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Call Option
Example - Google
What is the price of a call option given the following?
P = 430
EX = 430

r = 3%
t = 180 days / 365

= .4068

OC N ( d 1 ) P N ( d 2 ) ( EX ) e rt

We should use
continuous
discount rate

OC .5774 430 .4632 ( 430 ) / 1 .015

OC $ 52 .04

But we
approximate
here using 1.5%
for 6 months

Implied volatility

The most important unobservable variable in the option price is volatility.

This figure can be estimated, forecasted, or derived from the other variables used to calculate the option price, when the option price is known.

35

Real options (continued from 4th lec)

Traditional discounted cash-flow approaches (such as the NPV rule)

cannot properly capture managements flexibility to adapt and revise
later decisions in response to unexpected market developments.
Traditional approaches assume an expected scenario of cash-flows
and presume managements passive commitment to a certain static
operating strategy.

The real world is characterized by change, uncertainty and

competitive interactions =>
As new information arrives and uncertainty about market conditions is
resolved, management may have valuable flexibility to alter its initial
operating strategy in order to capitalize on favourable future opportunities
or to react so as to mitigate losses.
This managerial operating flexibility is like financial options, and is known as
Strategic Options, or Real Options.
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From4thlecture

Real Options in Capital Budgeting (repeated)

Expansion options

Abandonment
options

Follow-on
investment
options
Flexibility options
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If a product is a hit, expand production

(call option).

Firm can abandon a project if not

successful (put option).
Shareholders have valuable option to
default on debt.
Similar to expansion options, but
more complex (Ex: movie rights to
sequel)
Ability to use multiple production
inputs (Ex: dual-fuel industrial boiler)
or produce multiple outputs

Flexibility & Real Options

We first analyise the value of an option by decision
trees.
Decision Trees - Diagram of sequential decisions and
possible outcomes.
Decision trees help companies determine their Options
by showing the various choices and outcomes.
The Option to avoid a loss or produce extra profit has
value.
The ability to create an Option thus has value that can be
bought or sold.
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Applying B-S to real options

Usually there are no markets for underlying assets

The value of underlying asset may not follow the continous
stochastic process that B-S assumes
The standard deviation is therefore difficult to assess and it
may also change during the life of an option.
Determination of an exercise price may be difficult task
There might be no possibilities for immediate exercise of an
option.

39

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Xisexerciseprice,orstrikepricebutin
slide27weusednotationEX

P
EX

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Option to delay

The company has exclusive rights to the product or project

and can postpone the investment if necessary
Can also start with smaller scale investments and depending
on the experience expand the project
The traditional approach based on NPV and IRR gives one
answer is it worth to start today based on information
available also today.
A good starting example would be the project based on
natural resources (prospects for crude oil exploitation).
We are going to have at least two examples of real options in
the seminar
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Barriers to Real Options

Practical reasons exist why real options are not always feasible to
use.
1.

2.
3.

Valuation of real options can be complex and sometimes it is

impossible to arrive at the perfect answer. Inputs to valuation
are difficult or sometimes impossible to obtain without a large
measurement error.
Real options do not always have a clear structure of their path
and cash flows.
Competitors also have real options, which can alter the value of
your options by altering the underlying assumptions and
environment that serves as the basis of your valuation.
Given these limitations, real options are not always the best
approach when valuing projects.

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