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CORPORATE FINANCE Financial and Real Options

CORPORATE FINANCE Financial and Real Options. GENERAL AGENDA. Financial and Real Options. TOPICS COVERED. Calls, Puts and Shares Financial Alchemy with Options What Determines Option Value Option Valuation Real Options Follow Up Investments Abandon Wait Vary Output or Production

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CORPORATE FINANCE Financial and Real Options

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  1. CORPORATE FINANCEFinancial and Real Options

  2. GENERAL AGENDA Financial and Real Options

  3. TOPICS COVERED • Calls, Puts and Shares • Financial Alchemy with Options • What Determines Option Value • Option Valuation • Real Options • Follow Up Investments • Abandon • Wait • Vary Output or Production • Binomial Model

  4. OPTION TERMINOLGY Call Option Right to buy an asset at a specified exercise price on or before the exercise date. Put Option Right to sell an asset at a specified exercise price on or before the exercise date.

  5. OPTION OBLIGATIONS

  6. OPTION VALUE The value of an option at expiration is a function of the stock price and the exercise price.

  7. OPTION VALUE • The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given a exercise price of $85

  8. OPTION VALUE Call option value (graphic) given a $85 exercise price. Call option value $20 85 105 Share Price

  9. OPTION VALUE Put option value (graphic) given a $85 exercise price. Put option value $5 80 85 Share Price

  10. OPTION VALUE Call option payoff (to seller) given a $85 exercise price. Call option $ payoff 85 Share Price

  11. OPTION VALUE Put option payoff (to seller) given a $85 exercise price. Put option $ payoff 85 Share Price

  12. OPTION VALUE Protective Put - Long stock and long put Long Stock Position Value Share Price

  13. OPTION VALUE Protective Put - Long stock and long put Long Put Position Value Share Price

  14. OPTION VALUE Protective Put - Long stock and long put Long Stock Protective Put Position Value Long Put Share Price

  15. OPTION VALUE Protective Put - Long stock and long put Protective Put Position Value Share Price

  16. OPTION VALUE Straddle - Long call and long put - Strategy for profiting from high volatility Long call Position Value Share Price

  17. OPTION VALUE Straddle - Long call and long put - Strategy for profiting from high volatility Long put Position Value Share Price

  18. OPTION VALUE Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Position Value Share Price

  19. OPTION VALUE Straddle - Long call and long put - Strategy for profiting from high volatility Straddle Position Value Share Price

  20. OPTION VALUE Strip – 1 Long call and 2 long put - Strategy for profiting from high volatility Long call Position Value Share Price

  21. OPTION VALUE Strip – 1 Long call and 2 long put - Strategy for profiting from high volatility 2 Long put Position Value Share Price

  22. OPTION VALUE Strip – 1 Long call and 2 long put - Strategy for profiting from high volatility Strip Position Value Share Price

  23. OPTION VALUE Strip – 1 Long call and 2 long put - Strategy for profiting from high volatility Strip Position Value Share Price

  24. OPTION VALUE Strap – 2 Long call and 1 long put - Strategy for profiting from high volatility 2 Long call Position Value Share Price

  25. OPTION VALUE Strap – 2 Long call and 1 long put - Strategy for profiting from high volatility Long put Position Value Share Price

  26. OPTION VALUE Strap – 2 Long call and 1 long put - Strategy for profiting from high volatility Strap Position Value Share Price

  27. OPTION VALUE Strap – 2 Long call and 1 long put - Strategy for profiting from high volatility Strap Position Value Share Price

  28. OPTION VALUE Stock Price Upper Limit

  29. OPTION VALUE Stock Price Upper Limit Lower Limit (Stock price - exercise price) or 0 whichever is higher

  30. OPTION VALUE Components of the Option Price 1 - Underlying stock price 2 - Striking or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate)

  31. OPTION VALUE Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt

  32. Black-Scholes Option Pricing Model OC = Ps[N(d1)] - S[N(d2)]e-rt OC- Call Option Price Ps - Stock Price N(d1) - Cumulative normal density function of (d1) S - Strike or Exercise price N(d2) - Cumulative normal density function of (d2) r - discount rate (90 day comm paper rate or risk free rate) t - time to maturity of option (as % of year) v - volatility - annualized standard deviation of daily returns

  33. Black-Scholes Option Pricing Model Ps S v2 2 ln + ( r + ) t (d1)= v t N(d1)= 32 34 36 38 40

  34. Cumulative Normal Density Function Ps S v2 2 ln + ( r + ) t (d1)= v t (d2) = d1 - v t

  35. CALL OPTION Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365

  36. CALL OPTION Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 Ps S v2 2 ln + ( r + ) t (d1) = v t (d1) = - .3070 N(d1) = 1 - .6206 = .3794

  37. CALL OPTION Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 (d2) = d1 - v t (d2) = - .5056 N(d2) = 1 - .6935 = .3065

  38. CALL OPTION Example What is the price of a call option given the following? P = 36 r = 10% v = .40 S = 40 t = 90 days / 365 OC = Ps[N(d1)] - S[N(d2)]e-rt OC = 36[.3794] - 40[.3065]e - (.10)(.2466) OC = $ 1.70

  39. OPTION TO WAIT Intrinsic Value Option Price Stock Price

  40. OPTION TO WAIT Intrinsic Value + Time Premium = Option Value Time Premium = Vale of being able to wait Option Price Stock Price

  41. OPTION TO WAIT More time = More value Option Price Stock Price

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