Financial Valuation Methods: Part 2_M7

Question 1

What are the stock valuation models?

Answer 1

1. The Binomial (Cox-Ross-Rubinstein) Model - American style of option valuation model that you can exercise options at any time before maturity.
2. The Black Scholes Model - European style of option valuation that you can only exercise the option on the date of maturity.

Question 2

What are the stock valuation models?

The Binomial Model 1 of 2

Answer 2

The Binomial (Cox-Ross-Rubinstein) model is actually a variation of the Black-Scholes option pricing model.

• There are two primary differences
  1. it can be used for stocks that pay periodic dividends without modifying the model.
  2. It is American style and can be exercised at any time before expiration.
• Similar to the Black-Scholes model in that they BOTH assumes no transaction costs or taxes included in the model.

Question 3

What are the elements of the Black-Scholes model?

2 of 2 stock valuation models The Black Scholes Model

Answer 3

• Stock options are exercisable only at maturity/expiration date - European-style options.
• Model assumes no taxes or transaction costs exist.
• Underestimates extreme price movements. - Draw back of the model.
• Assumes that stocks do not pay dividends; however, the model can be adapted to dividend-paying stocks.
• the risk-free rate and volatility of the stock prices are constant over the option’s life.
• Stock prices behave in a random manner.

Inputs to the Black Scholes Model
* current price of the underlying stock.
* the option exercise price.
* the risk-free interest rate.
* the time until expiration.
* a measure of risk tied to the underlying stock.

Question 4

What is the Black-Scholes model?

Answer 4

Is a model used to determine the fair
values for call and put options.

Question 5

How to calculate the bonds price?

Calc one year at a time to maturity final year each year has a new power

Answer 5

If the bond pays a higher coupon rate than market rate, it will be issued at a premium to par. The bond’s price can be calculated as follows:
Year 1 payment: 600/1.05 = $571.43
Final Year payment Yr. 2: (600 + 10,000) x 1.05 ^2 = $9,614.51
Total value: $571.43 + $9,614.51 = $10,185.94

PYMT Amt. $600 = 6% coupon rate x face value $10,000 | 5% is the market rate

Question 6

What does the bond price mean at issuance?

Answer 6

• If Stated/Coupon rate (what issuer actually pays investor/bondholder) is less than face value/Market Value, the bond is issued at a discount.
• If Stated/Coupon rate is more than face value/Market Value, the bond is issued at a premium.
• If Stated/Coupon rate is equal to face value/Market Value, the bond is issued at par.

Question 7

What are the rules for approving Estimates?

Answer 7

• Must be reviewed on a periodic basis.
• Must be approved by management.

Question 8

What are the similarities and differences in the binomial (Cox-Ross-Rubinstein) model vs. the Black-Scholes pricing model for valuing stock options?

Answer 8

Similarities

• They both assumes no transaction costs or taxes

Differences

• The Binomial (Cox-Ross-Rubinstein) consideration of the option over a period of time.
• The Binomial (Cox-Ross-Rubinstein) can be used for stocks that pay dividends without model modification.