1 Options

2 Options Financial Options There are Options and Options - Financial options - Real options

3 Options Financial Options A financial option gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date. Puts Calls Strike price/Exercise price American/European

4 Table 20.1 Option Quotes for Amazon.com Stock

5 Options Financial Options Option Pricing Binomial - Two state single period - Law of one price - Replicating portfolio Call option, SP 50, No dividend, Stock will either rise by 10 or fall by 10 Risk free rate is 6%

6 Options Financial Options/Pricing Stock Bond Call max (60-50,0) = Stock 50 Bond max (40 -50,0) = 0 60 = up and 40 = down S = Share price and t = number of shares and B = investment in the bond. SP = 50

7 Options Financial Options/Pricing Value of portfolio containing the stock and the bond must = the value of the portfolio in each state. 60St B = 10 40St B = 0 So St =.5 And B = x x = x.5 – 1.06 x = 0

8 Options Financial Options/Pricing Generalising we get St = C u – C d and B = C d – S d t S u – S d 1+r f This gives us the replicable portfolio The Call option price then follows C = St + B or 50x.5 – (1) = 6.13

9 Options Financial Options/Pricing But what about multi period models? Strike price of 50, R f = 6% Periods

10 Options Financial Options/Pricing We start at the end and work back Max(60 -50,0) = 10 Max ,0) = 0 This is the same as before therefore St =.5 and B = and the call value at time 1 is 6.13

11 Options Financial Options/Pricing What if share dropped to 30 in the next period (period 1)? 30 40Max (40 – 50, 0) = 0 20 Max (30 – 50, 0) = 0 The option is worthless in both states so no portfolio value

12 Options Financial Options/Pricing Now move back a period Stock Call Now work out replicating portfolio at time 0 St = C u – C d = 6.13 – 0 = S u – S d 50 – 30 B = C d – S d t = (0.3065) = r f 1.06

13 Options Financial Options/Pricing So the Call value at Time 0 is C = St + B = 40(0.3065) +(-) 8.67 = 3.59

14 Options Financial Options/Pricing For European options if we let each period shrink to zero and have an infinite number of periods then we may use the Black-Scholes formula to calculate the binomial pricing………….. but we wont But remember the important factors in the pricing

15 Options Financial Options/Pricing The strike price The stock price The exercise date The risk free interest rate The volatility

16 Options Real Options And there are Real Options The right to take a particular business decision e.g. a capital investment decision. Main distinction is that the asset is normally not traded

17 Options Real Options Until now we have considered a stream of cash flows during the project, starting from today, to determine the NPV But what about alternatives such as delaying the start or abandoning the project after a while?

18 Options Real Options To analyse the alternatives we need Decision Trees A graphical representation of future decisions and uncertainty resolution (B & DeM)

19 Options Real Options Meet (re meet) Megan Goes to markets Sells, average profit 1,100 Costs of Booth 500, in advance Go to meet Stay at home profit 1,100 – 500 = 600 0

20 Options Real Options Now add some uncertainty If it rains (25% chance) she will make a loss = -100 If it is sunny her profit is higher = 1,500

21 Options Real Options Go to meet sunshine 75% 1,500 Stay at home Rain 25% Decision node Information node

22 Options Real Options Go to meet or not? Dont pay for booth Pay for booth Sunshine 75% Rain 25%Go to meet Stay at home Go to meet 1,

23 Options Real Options So what is the value of this real option to Megan? Expected profit without choice i.e. go to meet regardless = 1,500 x x.25 = 1,100 Expected profit with choice = 1,500 x.75 = 1,125 So choice/option worth 25

24 Options Real Options Should Megan pay for the booth? Expected profit will be = 625 So Yes

25 Options Real Options When else may they be used? -Option to delay Invest now only where NPV is substantially greater than zero But What are costs of delay? What is volatility? What are costs of investment?

26 Options Real Options Option to Grow Option to Expand Option to Abandon Option to Prepay