C15 Real Options I

Question 1

What is a financial option?

Answer 1

Financial option: Contract giving its owner
the right (but not the obligation) to buy or sell an asset at a fixed price at some future date.

Question 2

Real vs financial options

Answer 2

• *Real option: right to make a particular business decision, such as a capital investment. … buy or sell a specified quantity of an underlying asset at strike price at or before the expiration date of the option)
  difference: real options, and the underlying assets on which they are based, are often not traded in competitive markets.**

Question 3

DCF models and real options

Answer 3

DCF models underestimate the value of investments, where options are embedded in the underlying investment.
=>Real option advocates a premium on DCF value estimates

Question 4

Types of real options

Answer 4

DELAY: delay or defer making the investment
FLEXIBILITY: adjust or alter production schedules as price changes
EXPANSION/GROW: expand into new markets or products at later stages in the process, based upon observing favorable outcomes at the early stages
ABANDONMENT: stop production or abandon investments if outcomes are unfavorable at early stages

Question 5

3 basic questions for real options

Answer 5

(1) When is a real option embedded in a decision or asset (conditions for a real option)?
(2) When does the real option have significant economic value?
(3) Can the value be estimated using an option pricing model?

Question 6

Conditions for a real option

Answer 6

(1) Clearly defined underlying asset whose value changes over time in unpredictable ways
(2) Payoffs on this asset (real option) have to be contingent on a specified event occuring within a finite period

Question 7

Call option: definition and payoff

Answer 7

Question 8

Put option: definition and payoff

Answer 8

Question 9

When does an option have significant economic value?

Answer 9

Restriction on competition in the event of the contingency
at the limit, real options are most valuable when you have exclusivity

Question 10

formula Value of call option

Answer 10

C = max (S - K, 0)
S: stock price; K: strike price (exercise price)

Question 11

Determinants of option value (3 categories)

Answer 11

Variables wrt underlying asset
Variables wrt option
level of interest rates

Question 12

Determinants of option value: variables wrt underlying asset

Answer 12

(1) value of underlying: increase in underlying’s value will increase value of calls and decrease value of puts
(2) variance in value of underlying: increasing variance increases both values, for calls and for puts as both are downside limited and upside depends upon price volatility
(3) expected dividends on asset: dividends are likely to reduce the price appreciation component of the asset, reducing call value and increasing put value

Question 13

Determinants of option value: variables wrt option

Answer 13

• *Strike price of options**: a higher strike price decreases value of calls and increases value of puts
• *life of the option / expiration date**: both calls and puts benefit from longer life

Question 14

Determinants of option value: level of interest rates

Answer 14

level of interest rates: increasing interest rates increase value of calls and reduce value of puts

Question 15

When can you use option pricing models to value real options?

Answer 15

Option pricing models are best suited for valuing real options when
(1) Underlying asset is traded: for purposes of gaining input in terms of prices and volatility as well as to allow for the possibility of creating replicating PF’s
(2) An active marketplace exists for the option itself
(3) Cost of exercising the option is known with some degree of certainty
Be aware that…
value estimates are more imprecise
value can deviate much more dramatically from market price due to difficulty of arbitrage

Question 16

Black-Scholes model

Answer 16

…model to value European call options
Inputs (correlation in brackets):
S(+) = current stock price of Underlying
K(-) = Strike Price
T(+) = Life to expiration of option
rf(+) = riskless interest rate wrt. T
σ2(+) = Variance in ln(value) of Underlying
For dividend-paying stocks: Sx = S - PV(Div), Sx: stock price excluding dividends, Div(-): dividends paid prior to expiration date

Question 17

Option to delay: interpretation of inputs

Answer 17

Input for Black-Scholes:
S: current market value of underlying asset
K: upfront investment
T: final decision date
rf: risk-free rate
σ: volatility of asset value
Div: FCF lost from delay

Question 18

Option to delay: steps to undertake

Answer 18

• *1.** Calculate value of asset if not delayed: V=S = ∑tTFCF/ (r-g) with r: cost of capital
• *2.Calculate NPV = - K + V3.** Calculate Sx and PV(K)
• *4.** Calculate current value of C via Black-Scholes using Sx and PV(K)
• *5.**If C > NPV(S): Decide to wait; value of the contract is C

Question 19

Factors affecting timing of investment

Answer 19

Invest today if NPV of investing today: NPV(S) > Cwait
Investment that currently has a negative NPV can have a positive one given the option to wait
Other factors affecting the decision:
Volatility: Cwait is most valuable if the uncertainty is high
Dividends (costs of delay): in real option context it is never optimal to exercise an option to delay early (unless there are costs to doing so: FCF lost from delay)