Week 10 Real options Flashcards
What is shiller’s Definition of a bubble?
- Investor enthusiasm spread via stories that justify a price
What causes a bubble?
Caused by irrational investing decisions and fear of missing out
Are bubbles rational or irrational?
Both
Rational view
- investors are placing high valuations to capitalise on the firm’s options in the future
(acting like call options)
Irrational view
- “noise investors” following the crowd to try capitalise on rising prices
What is a unicorn?
What causes a unicorn?
Privately held start up with a valuation of 1b
Caused by:
- Winner takes all attitude of tech industry
- High valuations are usually caused by a single investor’s latest contribution that devalues all shares above 1b
What are the three points to evaluate when trying to “know” a firm?
- Role of stories
- Real options value of investment
- Different kinds of real options
What is the importance of a story to a growth stock?
- They share their vision to try open the eyes to investors to their growth options
- growth options are not accounted for in standard DCF models
What are options?
-Provide flexibility to undertake a course of action contingent on particular outcomes
What is a call option?
The right to buy an asset as a specific exercise price on or before a specific expiry date
The riskier the company, higher value call options
What is a put option?
The right to sell an asset at a specific exercise price on or before a specific expiry date
What is the contrast between high valuations and call options?
High valuations that are not justified by cashflows can be viewed like a call option for the company
Expiry date: infinite
What are the factors determining an options value?
- underlying asset value
- Exercise price
- Volatility
- Time to maturity
- Risk free rate
How does an increase in each factor affect a call options value?
Underlying asset value= Increase
Exercise price = decrease
Volatility = increase
Time to maturity = increase
Risk free rate = increase
How does an increase in each factor affect a put options value?
Underlying asset value= decrease
Exercise price = increase
Volatility = increase
Time to maturity = increase
Risk free rate = increase
What are Financial options?
The right to sell or buy a security at a given price at a given time in the future
What is a real option?
The right to be flexible in ones future decisions regarding risky investments
What are real options critiques of DCF analysis?
If expected cashflows do not reflect the owners real options, the investments value will be understated
- The owner can exercise real options to abandon or expand to mitigate risks
Therefore, DCF analysis does not account for the investments ability to control risk
