Real Options Flashcards
What is the formula for price
P = ( sum of expected cash flow discounted back) + growth options
What is the formula for expected cash flow and how does this yield the intrinsic value or market price
Sales Volume x Profit Per sale = Free cash flow
Profit per sale = Net Income / Revenues, = how much of every dollar of sale a company actually keep in earnings or Net profit / Sales
Expected free cash flow is discounted to yield present value of future Cash Flows
PV of FCF + Growth options = Intrinsic Value
Define what a derivative is and explain how they get their value
Securities that get their value from the price of other securities
Derivatives are contingent claims because their payoffs depend on the value of other securities. Value is derived from underlying asset.
Options are example of derivatives
Define a call option and a put option
Call option: The right to buy an asset at a specified exercise price on or before a specified expiration date
Put option: The right to sell an asset at a specified exercise price on or before a specified expiration date.
What is the function to price a call option
d
The value of the option is a function of
- Value of underlying asset
- Exercise Price
- Volatility
- Time to maturity
- Risk-free rate of interest
If there is an increase in these underlying function does the price of an option increase or decrease.
FORMULAS FOR CALL AND PUTS IN WORD DOC
Call / Put
- Value of underlying asset increases then the Value of the call will increase and the value of the put will fall
- If exercise price increase then the value of call will fall and the value of the put will increase, you need to buy the asset for a higher price.
- If the volatility of the underlying asset increases so does the the value of the call or put. If you look at the probability distribution the one that is flatter (larger standard deviation) the more valuable the option)
- An increase in time to maturity will increase in the value of the option irrespective if it is a call or a put. There is more time for the option to be in the money. Consider if you had one day to expiry as opposed to 1 year.
- If the risk free interest rate increase the value of the call option will increase and the value of the put option will fall (Look at the formulas)
A high interest rate allows the investor to earn a higher rate of return on the capital that was used to purchase the option on the underwritten asset rather than buying the asset itself.
An increase in the risk-free rate will cause the value of a put option to fall. YYYY
What is the purchase price of an option referred to as, who receives this income and what their obligations for taking income
The purchase price of the option is called the premium.
Sellers (writers) of options receive premium income.
If holder exercises the option, the option writer must deliver the underlying asset (call) or delivery of the underlying asset (put)
Give the conditions that set call and put options in the money, out of the money and at the money.
In the Money: exercise of option is profitable
Call: exercise price Market Price
Out of the Money: exercise of option not profitable
Call: market price Exercise Price
At the Money - exercise price and asset price are equal
Draw a payoff and profit diagram for a call option with a strike price of $100 and option premium of $14 for both holder and writer
Put Graphs in Pg 11 of Lecture slides
Profits unlimited for holder
Draw a payoff and profit diagram for a Put option with a strike price of $100 and option premium of $14 for both holder and writer
Put Graphs in Pg 11 of Lecture slides
Profits limited for the holder
Initial investment 10 000
Share price $100
Option: $10 Underwritten on 1 000 share
Assume two investment strategies invest everything in options or all in shares, at the prevailing share price $95, $100, $105, $110, $115
What is the implication
Equity only $95 = 9 500 = -5% $100 = 10 000 = 0% $105 = 10 500 = 5% $110 = 11 000 = 10% $115 = 11 500 = 15%
Options Only $95 = 0 = - 100% $100 = 0 = - 100% $105 = 5000 = - 50% $110 = 10 000 = 0% $115 = 15 000 = 50%
The all option portfolio responds more proportionately to changes in share value; it is levered
Options are riskier, you more likely to lose money but the upside gain is also increased.
Define a real option as opposed to a financial option.
Give an example of real options and what is the major implication
Financial option: The right to buy or sell a security for a given price at a given time in the future
Real option: An alternative or choice that become available with a business investment opportunity. Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options.
This kind of option is not a derivative instrument, but an actual option in a sense of choice that a business may gain by undertaking certain endeavors.
Examples: After investing in a particular project, a company may have the real option of expanding, downsizing or abandoning other projects in the future.
The choice we make will be one that maximizes our profits.
The relevant point is that having real options increases our
expected profit!
Explain the Real option critique of Standard NPV
Standard NPV analysis discounts the expected values of cash flows.
If the expected cash flows of a risky investment do not reflect the owner’s real options they will be understated. People can change their mind and take a different course of action later down the track, so they can minimize the loss or change the operation to capture more of their profits.
The expected cash flows for a risky asset, where the owner can learn from observing what happens in early periods will be understated because NPV analysis will not capture the reduction of downside risk from the option to abandon and the expansion of upside potential from the options to expand and delay
DCF analysis underestimates the value of projects where
the owner has the facility to exercise an option to expand
the project or exercise an option to abandon the project or
exercise an option to delay further investment in response
to new information
What was the big difference in the crash of the dot com bubble and the GFC
Value of equity dropped around 5 trillion in the dot com bubble compared to 3 trillion in the GFC but the impact of the GCF was significantly more severe.
This helped spark a recession that lasted eight months and shrank GDP by 0.3%, compared to the GFC some countries haven’t even recovered yet in 2015.
WHY?????
What are arguments for and against a tech bubble forming in the market now
For
“This time is indeed different, though not because the boom-and-bust cycle has miraculously disappeared. It is different because the tech bubble-in-the-making is forming largely out of sight in private markets and has a global dimension that its predecessor lacked.
“The bubble is being pumped by wealthy “angel” investors, some of whom made their fortunes in late - 1990s IPO Boon
“today we are talking about real companies making real money so it a completely different time now”
Against
“the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that “this time is different”
