01 Week Flashcards
What is the Exercise Value of an Option?
max(0, Current S - X)
What are the assumptions of the Binomial model?
- Stock price S follows multiplicative binomial process
- Trading only at discrete times
How is p defined?
a probability for the upward movement in a world with risk neutral investors
What are the assumptions of the Black-Scholes Option Pricing Formula?
- Stock price moves randomly in continuous time (Brownian motion, const variance)
- No dividends
- No market friction
What is the Black-Scholes Option Pricing Formula?
Continuous-time option pricing formula for European call
What kind of option is Equity?
Equity is call option on the market value of the firm with the dept value as strike
When should a project be accepted according to the NPV-Method
If it increases shareholders wealth
What is the implicit assumption of the NPV-Method and what is the consequence?
Precommitment to a deterministic course of action
NPV-Method is not suitable for flexible, multi-period decision making under uncertainty
What is an Expansion Option?
Growth option on an underlying asset that assumes precommitment of a series of investments to growing demand over time
What type of Option is an Expansion Option?
American call
exercise price = cost of expandable investment
option value = multiple of the value of the underlying risky asset
What is a Contraction option?
Option to receive cash for partially giving up the use of asset
What type of Option is a Contraction option?
American put
exercise price = present value of cash
value of underlying = fraction of the value of operations given up
What is an Abandonment option?
Right to sell an asset for given price, which can change through time rather than continuing to hold it
What type of Option is an Abandonment option?
American put
What is an Extension Option?
Allows manager to pay a cost for the ability to extend the life of a project
What type of Option is an Extension Option
European call
Exercise Price = const of extension
What is a Deferral option?
Right to defer the start of a project
What type of Option is a Deferral option?
American call
What is a Switching option?
Richt to turn a project on and off
What is a Compound option?
Options on options
What is the difference between real option pricing and decision tree?
brach-dependent discount rate with real option pricing
How does DTA discount?
with adjusted discount rates for risk (WACC)
How does ROA discount=
with risk-free discount rates and adjusted probabilities for risk => risk neutral prob p
What are the key Assumptions of ROA
- Present value of project without flex, can be used as twin security
- Real Option Pricing obeys the principle of no-arbitrage
- Properly anticipated price fluctuate randomly
Disadvantages of NPV
- No flexibility after investment decision
- Underestimates the value of a project
Advantages of NPV
+ Simple to implement
Disadvantages of DTA
- Does not obey to the law of one price
- A constant WACC is assumed
- Physical probabilities have to be determined
Advantages of DTA
+ Incorporates flexibility
Advantages of ROA
+ Incorporates flexibility
+ Arbitrage-free valuation
+ Valuation is not based on physical probabilities
