Module 1: Option Pricing Application of BSOP model to value option to expand, delay, withdraw and redeploy- Factors that influence the value of the options-Greeks. Financial Derivatives Options ‘The right but not an obligation, to buy or sell a particular good at an Forward Contracts exercise price, at or before a Customised instruments to buy or sellanasset at a specified future (S607) rcoctiiecl cats: ‘date at a predetermined price. ‘Swap Contracts Instruments that require the Futures Contracts counterparties to exchange cash ‘Standardised instruments to buy or flows at specified intervals on or sellan asset at a specified future before a maturity date. date at a predetermined price. OPriOns DRIVERS OF VALUE BLACK-SCHOLES REAL OPTIONS, Risk-free rate Call options Types Seerclow price Gptions. “ Btock:Scholes Price of underlying Uritations Time to expiry Further applica 41 The principies of option pricing theory Option terminology [An option ‘The right but net an obligation, to buy or sell a Particular good at an exercise price, at or before a Specified date. Call option The right but not an obligation to buy @ particular goed al an exercise price, Put option The right but not an obligation to sell a particular good at an exercies price. Exercise/strike price The fixed price at which the good may be bought or sola. American option An option that can be exercised on any day up until is expiry date. European option ‘An option that can only be exercised on the last day of the option. Premium The cost ef an option. Traded option Standardised option contracts sold on a futures exchange (normally american eptions). Over the counter ‘Tailer-made option — usually sold by a bank (normally, (OTC) option European options). Option value The key aspect to an option’s value is that the buyer has a choice whether or net to use it. Thus the option can be used to avoid downside risk exposure withoul foregoing upside exposure,Option Value Intrinsic Value ‘Compares exercise price with the price of the underiying asset. Value of the call option will Increase as the share prics Wicreases. Value of an option ie equal to ite intrinsic value on the expiry date. Extrinsic Value (Time Value) Time to expiry Longer the period to expiry, higher the call option value Volatility of the share price Greater the volatility, higher the call option value Risk-free interest rate Higher the risk free rate, higher the call option value The time value. - Time to expiry. — AS the period to expiry Increases, the chance of a profit before the expiry date grows, increasing the option value. + Volatility of the chare price. — The holder of a call option does not suffer if the share price falle below the exercise price, Le. there is 2 limit to the downside. — However the option nolder gains if the share price increases abowe the exercise price, i.e there is no limit ta the upside — Thus the greater the volatility the better, as this increases the probability of a valuable Increase in share price, + Risk-free interest rate. — As stated above. the exercise price nas to be paid in the future, therefore the higher the interest rates the lower the present value of the exercise price. This reduces the cost of exercising and thus adds value to the current call option value. — Alternatively, since having a call option means that the share Purchase can be deferred, owning a call option becomes more, valuable when interest rates are high. since the money left in the Bank will be generating @ higher return.Option Value Cees tener Share price Increase Decrease Exercise price Decrease Increase Time to expiry Increase Increase Volatiity Increase Increase Interest rate Increase Decrease ‘Test your understanding 4 ‘Complete the following table fer put options. Summary of the determinants of call option prices: Increase in cal Put Share price Increase Exercise price Decrease Time to expiry Increase Volatility Increase Interest rate Increase Test your understanding 1 Summary of the determinants of option prices. Increase in Gall Put Share price Increase Decrease Exercise price Decrease Increase Time to expiry Increase Increase Volatility = s Increase Increase Interest rate Increase Decrease ‘Comments: * Share price and exercise price — apposite of call option. + Time and volatility — same argument as for call * Interest rate — a higher interest rate reduces the present value of deferred receipts making the option less valuable as. an alternative te selling now.Test your understanding 2 ‘A pension fund manager is concerned that the walue of the stock mmunricest will fel Required: Suggest an option strategy the manager could use to protect the Test your understanding 2 Buying put options would allow the manager to limit the downside exposure, Drivers of Option Value NA = Share price or market price of underlying asset lUnderiying Asset 1 incase of range, average is considered as the value of the asset. Exercise Price + Stated in the terms of the option contract. Bre coet at) + Stated in the terms of the option contract. + Standard deviation of day-to-day price changes in a security WES a] + Historical volatity ~ price changes of a security over a period of time + implied volatility current quoted options prices and backward calculation + Treasury bills eee Std aoe oe Determining these figures in practice is discussed below Value of the underlying asset + Fer quoted underlying assets a value can be lockad up on the market. Most markets give prices for buying and selling the Underlying ascet A mia price Is usually Used for opuen pricing, For example, if a price is quoted as 243-244 cents. then a mid- price of 243.5 cents should be used. = in the case of unquoted underntying assets, 2 separate exercise must be Undertaken to value then Fer example. suppose an unquoted company has issued share Options to employees ac part of inalr rormuneration package. TO Value thease call options (e.g. for dieclocure or taxation purposes? One must first value the shares using, og. PE ratios. Exercise price and time to expiry Both the exercise price and expiry date are stated in the terms of the option contract. Volatility + Volauiity represents the standard deviation of day-to-day price changes ina security, oxpressed Ss an annualised percentage. Two measures of volatility are commoenty used In options trading Historical and implied, + Historical volatility can be measured by observing price changes ofa security over a period of time. It is not necessarily a forecast of future Volatility, Dut can be used to determine the option price = Implied volatility can be calculated by taking current quoted Options prices and working backwards. You will never be asked te calculate the volatility (standard deviation) in the AEM omar. k-free rato. = The risk-free rate is the minimum return required by Investors from'a risk-free investment + Treasury bills or other chort-term (usually three months). Government borrowings are regarded as the cafest possible Investmont ang their rate of return is often given in a question to. Bo used as a figure fer tne rlektroe rate.Black-Scholes Option Pricing (BSOP) Model Value of a call option = Pz, N(d;) — P, N(d2)e~"* pa seated pie? aude ueuitece Wureeree == | Wane este the corealon eure! hes errane gies * Sia tecree ofa ; {Lime unt expiry of option in years _inG) + @+05s%e + 8 = volatility of the share price (standard deviation) c= svt egewe uectaneisne nee ye daca taleram amie ones + In= the natural logarithm logarithm base 'e| d,=d,;— svt Speneersery taaeees ae The current share price of & Go shares = S100 The exercise price sos The risk-free rate of interest 10% = 04 The standard deviation of return on the shares = s0% = os The time te expiry 3 months 0.25 Required: Calculate the value of the above call option. Solution In the CBE, you would enter the five figures here into the BSOP sproadsheat, and the spreadshest would be pre-programmed to give the following results: ds = 8.4302 de = 0.1802 Nid) = 0.6665 Nida) = 0.5715 e=13.70 Test your understanding 3 Suppose that the risk-free rate is 5% and the standard deviation of the Felurn on the share in the past has been estimated as 35%. Required Estimate the value of a six-month call option at an exercise price of $1.48 (current share price = $4-64). Test your understanding 3 Value of a call option = P= N(d:) — PeN(d2)je"* In the CBE, you would enter the five input variables into the BSOP- spreadsheet, and the spreadsheet would be pre-programmed to give the following results: ds = 0.6395 de = 0.3924 Nid») = 0.7388 N(d2) = 0.6525 = 0.27Value of a put option (P) = c — Py + Pe x e7T* + = Value of call option + Pa = current price of underlying asset (share price) + Pe = exercise price + 6 = risk-free rate of interest + t = time until expiry of option in years + @= the exponential constant (approx. 2.71828) Retuming to the earlier example of B Co. where the current share price is $100, exercise price is $95, the risk-free rate of interest is 10%. the standard deviation of shares return is 50% and the time to expiry is three months, calculate the value of a put option. Solution In the CBE, you would enter the five figures here into the BSOP. spreadsheet, and the spreadsheet would be pre-programmed to give the following result (as well as the results shown in the earlier example): p= 6.35 If you are interested to see how this number is calculated using the formula, the workings are shown below: + Step 1: We have already calculated the value of the call option at $13.70, + Step 2: Using put call parity equation: Put call parity p=c—P. +P. x e* Value of a put = 13.70 — 100.00 + 92.65 = $6.35 Note: There is no intrinsic value in this put option (the option is out of the money). The time value is $6.35 Test your understanding 4 Using the information given in TYU3, calculate the value of the corresponding put option. Test your understanding 4 In the CBE, you would enter the five input variables into the BSOP. spreadsheet, and the spreadsheet would be pre-programmed to give the following result (as well as the results shown in the earlier example): p=0.07 If you are interested to see how this number is calculated using the formula, the workings are shown below: Putecall parityp =c—Pa+ Peet Value of a put = 0.27 -1.644 1.44 = $0.07Option Greeks + Change in option value for a unit change in the value of the underlying asset. + Probability of an option being in the money (ITM) at expiration. + Calloptions ° Have a positive Delta that can range from 0.00 to 1.00. + At-the-money options usually have a Delta near 0.50. « Detta will increase (and approach 1.00) as the option gets deeper ITM. + Put options © Put options have a negative Delta that can range from 0.00 to -100. © At-the-money options usually have a Delta near -0.50. + Delta will decrease (and approach -1.00)as the option gets deeper ITM. Delta Hedges Strategy used to reduce the risk of price fluctuations. Hedged portfolio: © Portfolio where the gains and losses cancel out against each other. + Shares, call option, and put option are bought or sold to ensure hedged portfolio. Hedge Ratio Calculation: ’ Number of shares to hold = Number of call options sold! « Nici1) = Number of option calls to sell = Number of shares held / Nici1) Dynamic delta hedging: © Delta value changes continuously along the share prices © Investor will have to continuously adjust the balance of options and shares in their portfolio to maintain a risk neutral position. Cay + Rate of change of delta as the underlying asset's price changes. + As Delta cant exceed 1.00, Gamma decreases as an option gets further ITM. and Delta approaches 1.00. + Rate of deciine in the value of the option caused by the passage of time. + Also known as time decay. + Rate of decline is not linear.Warr + Rate of change in an option's price per 1% change in the implied volatility of ‘the underlying asset. + Adecrease in Vega will cause both calls and puts to lose value. + An increase in Vega will cause both calls and puts to gain value. Rho + Sensitivity of the option value to changes in the risk free rate of interest. + As interest rates increase, the value of call options will generally increase. + As interest rates increase, the value of put options will usually decrease. + Call options have positive Rho and put options have negative Rho. Collectively, delta, gamma, vega, rho and theta are known as "The Greeks’. The importance of the delta value has been illustrated above i.e. it is useful when setting up a delta hedge. The importance of the other Greeks included in the AFM syllabus is explained below. Gamma Ahigh gamma value indicates that the delta value is quite volatile. This means that it will be quite difficult for an option writer to maintain a delta hedge, since the volatile delta value will require the option writer to be constantly changing the number of options written. Therefore, gamma is a measure of how easy risk management will be. Theta An option price has two components, the intrinsic value and the time value. However, when the option expires, the time premium reduces to zero. Therefore, theta measures how much value is lost over time. Theta is usually expressed as an amount lost per day (e.g. theta could be —$0.06, indicating that 6 cents of value is lost per day). Theta usually increases as the expiry date approaches.CallOption Call Option Call & Put Option Options to ‘Options to ‘expand/follow-on delay/defer + Acjustthe scale of an + Delayinvestment to investment depending ‘Future date without ‘onthe marker losing the opportu. coraitions. + Valuable in uncertain + hit project provides ‘envronments ‘the option to accent future projects. Real Options in Investment Appraisal iffet There are many different classifications of real options. For the purposes of the AFM syllabus, we use the following four generic headings: Options to delay/defer The key here is to be able to delay investment without losing the opportunity, creating a call option on the future investment. Fl For example, establishing a drugs patent allows the owner of the patent to wait and see how market conditions develop before producing the drug, without the potential downside of competitors entering the market. (Note: Drugs patents was the subject of a past examination question on this. area. However, there is some debate whether or not patents are real options. This debate is outside the scope of the syllabus.) Options to switchiredeploy It may be possible to switch the use of assets should market conditions change.For example, traditional production lines were set up to make one product. Modern flexible manufacturing systems (FMS) allow the product output to be changed to match customer requirements. Similarly, a new plant could be designed with resale and/or other uses in mind, using more general-purpose assets than dedicated to allow easier switching rs For example, when designing a plant management can choose whether ta have higher or lower operating gearing. By having mainly variable costs, it is financially more beneficial if the plant does not have to operate every month Options to expand/follow-on It may be possible to adjust the scale of an investment depending on the market conditions. Options to abandon Ifa project has clearly identifiable stages such that investment can be staggered, then management have to decide whether to abandon or continue at the end of each stage. When looking to develop their stadiums, many football clubs face the decision whether to build a one- or a two-tier stand: * — Aoneetier stand would be cheaper but would be inadequate if the club’s attendance improved greatly. + Atwo-tier stand would allow for much greater fan numbers but would be more expensive and would be seen as a waste of money should attendance not improve greatly. Some clubs (e.g. West Bromwich Albion in the UK) have solved this problem by building a one-tier stand with stronger foundations and designed in such a way (@.9. positioning of exits, corporate boxes, etc.) that it would be relatively straightforward to add a second tier at a later stage without knocking down the first tier. Such a stand is more expensive than a conventional one-tier stand but the premium paid makes it easier to expand at a later date when (if!) attendance grows.[Link] undertook a substantial investment to develop its customer base, brand name and information infrastructure for its core book business. This in effect created a portfolio of real options to extend its operations into a variety of new businesses such as CDs, DVDs, etc. Test your understanding 5 Comment on a strategy of vertical integra’ options. nin the context of real Test your understanding 6 A film studio has three new releases planned for the Christmas period but does not know which will be the biggest hit for allocating marketing resources. It thus decides to do a trial screening of each film in selected emas and allocates the marketing budget on the basis of the results. Required: Comment on this plan using real option theory. Test your understanding 5 * Vertical integration is usually evaluated in terms of cost, quality and barriers to entry. * By outsourcing, the company can switch between different types af supply and different suppliers. * Vertical integration loses this flexibility, foregoing a switching option Test your understanding 6 The studio has effectively acquired a learning option allowing better subsequent decisions. The feedback generales a range of call options on future marketing investmentValuing Real Options NRC + Call Option - Value of the project being undertaken. ore ep cet + Butontion - PV of the future cash flows being foregone. 7 7 + Call Option - Capital investment required. EEC RED OE) + Put Option - Salvage value on abancionment. Sree c iat) + Time fin years) that is left before the opportunity to exercise ends. NSE Cat] + Can be measured using typical industry sector risk. 5 + Treasury bills GATOS + Government bonds Option to Expand ‘A company is considering a 10-year project which can be viewed as two phases: + Company has an option to expand and execute Phase 2 ce after 2 years. After 2 + Phase 2 does not seem worthwhile, However, the option come Dt years ‘to execute Phase 2 can only add value. Investment | $600m $300 m + If the cash flows expected from phase 2 became favourable, the company could carry it out and reap the ae benefit. annual sea7am | $2006m returns + Overall NPV will be $47.8m plus the value of the option to Ser a ar NPV $a78 $43) «+ The standard deviation of cash flows is 40%, and the risk-free rate is 5%. To value the Phase 2 option, first determine the value of variables required for the BSOP model Pe = Investment required = $300m Pa=PV of the net cash inflows currently forecast to arise = $s200.6m t= Time untilit begins = 2 years 8=Volatilty = 0.4 r= Risk-free rate = 5% Call option value = $24.22 m NPV for the project with the option to expand = $47.8m+ '$24.22m NPV for the project with the option to expand = $72.02m Company can benefit if the phase two expansion becomes worthwhile. Thus, the project can be considered.Question 2 An online DVD and CD retailer is considering investing $2m on improving its customer information and online ordering aystems. The expectation is that this will enable the company to expand by extending tts range of products. ‘A decision will be macie on the expansion in 1 years’ time, when the directors have had chance to analyse ‘detail, to assess whether the expansion ie Preliminary estimates of the expansion programme have found that an investment of 65min 1 year’s time will generate net receipts with a present vakie of &4m in the years thoreafter, The project's cash flows aro expected to be quite volatile, with a standard deviation of 40%, The current risk free rate of Interest Is 5%. Advise the firm whether the initial investment in updating the systems Is worthwhile. Determine the value of variables required for the BSOP model: Pe= 5m Pa=4m aaa 8 = 40% of 0.4 5% or 0.05 Call option value = $0.28 m Strategic NPV =-2 + 0.28 =-2.62 ‘The project should therefore be rejected. Question 3 ‘Bevyy is consiclering introducing a new fruit smoothie to the US market. The smoothie would initially be Introduced only in the major cities with an investment costing $500 milion, but the present value of the cash flows from this investment would be ony $400 milion. However, if the initial introduction of the smoothie works out well, Bevyy could go ahead with a full-scale Introduction to the entire market with an additional investment of $1 billion any time over the next five years. Although the current expectation ie that the present value of cash flows from making thie additional investment is only $750m, there is considerable uncertainty about the potential for the smoathi ‘The annualised standard deviation in the value of listed companies in the soft drinks industry Is 34.25%. The uield to maturity on five-year Treasury notes is 6%. \Value the option to expand production of the new smoothie and advise Bevyy whether to proceed with the project. Determine the value of variables required for the BSOP model: Pe = Cost of expansion into the entire US market = 1000 Pa = PV of cash flows from expansion = 750 t=5 8 = 34.25% or 0.3425 = 6% or 0.06 Call option value = $226.92 m NPV of limited introduction = 400 - 500 = -100, NPV of project with option to expand = -100 + 226.92 = 126.92 Bevvy should invest in the project.Question 4 ‘Amanufacturing company is considering investing in a small production plant for $2 milion. This plant is ‘expected to generate annual cash flows of $450,000 for 5 years. ‘The company also has an option to expand the plant after 3 years at an additional cost of $15 milion. IF ‘expanded, the plant’s cash flows will increase to $900,000 per year for the remaining 2 years. However, the expansion decision depends on market demand after 3 years. The standard deviation of cash flows is 30%, and the risk-free rate is 5%. Calculate the value of the option to expand. Should the company proceed with the initial investment, considering the potential value of the expansion option? A 8 c D t F 6 4 J Kk 1 Riker Ej 2 Sand detaton at a 4 Year 0 1 2 a 4 3 5 Inestment 290,00 6 Cash Fow- Phase 450000 45000 450000 450000 450,000 7 Basin Cost 80000 6 Adon Cason Phase 2 43000 _ 45,00 9 NetGash Flow 200,000" 450,000 _ 450,000 10,5000 $00,000 _9,0,000) 0 0F 1000 08520907 ames 11 DICash ow Drea 2000000 428,00 408150 _ 907200 7.40700 _ 7.6, 12 NPV-Oeral 42,350 a 14 (CeshFlon-Phase 1 -zneo.o0” 450000 45000 49000 450000 450,00] BOF 1000 08520907 ose ogts aT 16 PVCash low Pas 00.000 428400 408150 38600 370380 352,80 Ins Value 27 |NPV- Phase 1500 Eins abe Time Ve) 2 18 Cason Phase? v 0 0 500000 45000 450000 DoF tom 820907 abe ose Ise ae 21 VGashflon-Phase2 0 0 0 28600 7050 3.52009 Esti Ve (Te ae] 2. NV. Phase? Sn80 a 24 Optonvaue a0 5 NPVwithopton 920 BOption to Abandon ‘ABC Cos considering investing in the following project: + NPV= -8,000, so the project would be rejected. De ad + Suppose the company had the option to abandon the project after 2 years [T2) and to receive $70,000 for the sale of the assets, + Consider the value of this option to abandon, and ‘the impact on the decision. + Assume that the risk free rate is 5% and that the volatility associated with the project cash flows is 20%, Determine the value of variables required for the BSOP mode Pa = PV of CF foregone if we abandon = $30,000 + $35,000 = ‘$65,000 Pe = abandonment proceeds = $70,000 = standard deviation of the project cash flows = 20% ‘t= time until abandonment = 2 years r= risk free interest rate = 5% Put option value = $6416 m NPV for the project with the option to abandon = -8000 + 6416 NPV for the project with the option to expand =-1584 Innse Value Extrinsic Vale Time Value) Project is not acceptable even when considering the possibility of abandonment after two years. Question 5 ‘A company has developed a new process with the following data: + Conventional NPV = $10m + Capital expenditure = $90m + 10-year life + Volatility of the project's future cash flows = 45% + Risk-free rate = 5% The company has the option to abandon the project at any time and sell the technology for an estimated $40m. Use the Black-Scholes model to estimate the value of the abandonment option and the total value of the project.Determine the value of variables required for the BSOP model: Pa = underlying asset value = $90m + $10m = $100m Pe = selling price of exercising the option = $40m .05, t=10 years 3=0.45 Put option value = $5.03 m NPV of project with option to expand = 10m + §.03m=15.03m ‘This is stil conservative as the option is American-style but has been valued as European-style. Option to Delay Paradise Vilas, a property development company, has obtained planning permission to develop a complex of holiday apartments in a foreign state. The project has an expected net present value of $4m ata cost of capital of 10% per annum. Paradise Vilas has an option to acquire the necessary land at an agreed price of $24m, which must be exercised within the next two years. Immediate building of the complex would be risky as the primary purchasers of the apartments would be foreigners, and, at present, there are uncertainties over the legality of property sales to foreigners. As a result, the project has 25% volatility attached to its future cash flows. ‘The state’s government expects to make an announcement about the rights of foreigners to purchase property in the next two years. The risk-free rate of interest is 5% per annum. Use the Black-Scholes model to estimate the value of the option to delay the commencement of the project and state the total value of the project. Determine the value of variables required for the BSOP model: a = Present value of the project = $24m + $4m= $28m Pe = Capital expenditure = $24m 0. NPV of project with option to delay = 7.48m 7 Intrinsic value = Expected NPV = 4m Time value = 7.48m - 4m = 3.48m, ‘The time value represents the additional value of being able to ‘wait and see' the government ’s decision.Question 6 Manics Co is considering investing in the following project: Free cash flows -500 120 -200 160 ‘At a discount rate of 10%, the NPV of the project is positive (approx. $19.7m). This is a very small positive NPV, so some of the directors have expressed concerns about the sensitivity of the project to possible changes in the forecast cash flows. However, the financial manager feels that the project is being unfairly under-valued, so he has prepared some further analysis of the project. ‘The key to the financial manager's concern is that he feels that the large cash outflow at the end of year 2 is discretionary and does not have to be made (in particular if circumstances have changed and the project is not proving to be as successful as had been hoped). He has therefore spitt the original project into two: an initial investment of $500m which will produce net cash inflows of $120m for the following 8 years, anda further investment of $320m after two years which willincrease the net cash inflows by $40m to $160m per year for the remaining six years. Assume that s is 50% andr is 5%. A 8 c D E F c 41 Discountrate 10% 2. Riskteerate oH 3. Sandard deviation 50 4 5 6 Year Tal “Phase Phase2_—_Phase2(Cashlnfon) 70 0300 o a an mo 0 0 on m1) 38 0 078 om 4 r 1m eo 0 a Co) 125 ) 4 ri) BIB ae) ” C7 wa 0 0 rt) 518 0 4 4 6 17 NPV 1970 1un19 10.49 Evtnsc Value ime Value) 8 19 CallOptonvae 1183 20 Total NPV 152.02 Intinsic Value a Evtrinsic Va ime Vale) 2