01 Week

Question 1

What is the Exercise Value of an Option?

Answer 1

max(0, Current S - X)

Question 2

What are the assumptions of the Binomial model?

Answer 2

• Stock price S follows multiplicative binomial process

- Trading only at discrete times

Question 3

How is p defined?

Answer 3

a probability for the upward movement in a world with risk neutral investors

Question 4

What are the assumptions of the Black-Scholes Option Pricing Formula?

Answer 4

• Stock price moves randomly in continuous time (Brownian motion, const variance)
• No dividends
• No market friction

Question 5

What is the Black-Scholes Option Pricing Formula?

Answer 5

Continuous-time option pricing formula for European call

Question 6

What kind of option is Equity?

Answer 6

Equity is call option on the market value of the firm with the dept value as strike

Question 7

When should a project be accepted according to the NPV-Method

Answer 7

If it increases shareholders wealth

Question 8

What is the implicit assumption of the NPV-Method and what is the consequence?

Answer 8

Precommitment to a deterministic course of action

NPV-Method is not suitable for flexible, multi-period decision making under uncertainty

Question 9

What is an Expansion Option?

Answer 9

Growth option on an underlying asset that assumes precommitment of a series of investments to growing demand over time

Question 10

What type of Option is an Expansion Option?

Answer 10

American call
exercise price = cost of expandable investment
option value = multiple of the value of the underlying risky asset

Question 11

What is a Contraction option?

Answer 11

Option to receive cash for partially giving up the use of asset

Question 12

What type of Option is a Contraction option?

Answer 12

American put
exercise price = present value of cash
value of underlying = fraction of the value of operations given up

Question 13

What is an Abandonment option?

Answer 13

Right to sell an asset for given price, which can change through time rather than continuing to hold it

Question 14

What type of Option is an Abandonment option?

Answer 14

American put

Question 15

What is an Extension Option?

Answer 15

Allows manager to pay a cost for the ability to extend the life of a project

Question 16

What type of Option is an Extension Option

Answer 16

European call

Exercise Price = const of extension

Question 17

What is a Deferral option?

Answer 17

Right to defer the start of a project

Question 18

What type of Option is a Deferral option?

Answer 18

American call

Question 19

What is a Switching option?

Answer 19

Richt to turn a project on and off

Question 20

What is a Compound option?

Answer 20

Options on options

Question 21

What is the difference between real option pricing and decision tree?

Answer 21

brach-dependent discount rate with real option pricing

Question 22

How does DTA discount?

Answer 22

with adjusted discount rates for risk (WACC)

Question 23

How does ROA discount=

Answer 23

with risk-free discount rates and adjusted probabilities for risk => risk neutral prob p

Question 24

What are the key Assumptions of ROA

Answer 24

1. Present value of project without flex, can be used as twin security
2. Real Option Pricing obeys the principle of no-arbitrage
3. Properly anticipated price fluctuate randomly

Question 25

Disadvantages of NPV

Answer 25

• No flexibility after investment decision

- Underestimates the value of a project

Question 26

Advantages of NPV

Answer 26

+ Simple to implement

Question 27

Disadvantages of DTA

Answer 27

• Does not obey to the law of one price
• A constant WACC is assumed
• Physical probabilities have to be determined

Question 28

Advantages of DTA

Answer 28

+ Incorporates flexibility

Question 29

Advantages of ROA

Answer 29

+ Incorporates flexibility
+ Arbitrage-free valuation
+ Valuation is not based on physical probabilities