CH8 - Options & Real World Options Flashcards
Types
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.
Notes
- The higher the time to expiry, the more chance of profit, increasing option value.
- The greater the volatility the better, as there is no downside apart from the issue costs.
- 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.
- Also, since money left in the bank will generate a higher return, the call option is valued higher with higher interest rates.
Real Options Theory
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.
Types of ‘Real’ Options
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
Black Scholes Modelling Real Options:
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.
