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CHAPTER 15
Financial Options with Applications to
Real Options
Financial options
Black-Scholes Option Pricing Model
Real options
Decision trees
Application of financial options to
real options
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 2
What is a real option?
Real options exist when managers can
influence the size and risk of a project’s
cash flows by taking different actions
during the project’s life in response to
changing market conditions.
Alert managers always look for real
options in projects.
Smarter managers try to create real
options.
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15 - 3
Option Terminology
Table (Continued)
30
25
20
Market price
15
Exercise value
10
5 10 15 20 25 30 35 40 45 50
5
Stock Price
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15 - 13
V = P[N(d1)] - Xe -k t[N(d2)].
RF
d2 = d1 - σ t.
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15 - 17
V = $27(0.7168) - $25e-0.03(0.6327)
= $19.3536 - $25(0.97045)(0.6327)
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15 - 19
(More...)
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 22
Abandonment options
Contraction
Temporary suspension
Flexibility options
E(NPV) = [0.3($35.70)]+[0.4($1.79)]
+ [0.3 ($0)]
E(NPV) = $11.42.
$111.91
High
$67.82 Average $74.61
Low
$37.30
PV2001=PV of Exp. PV2002 = [(0.3* $111.91) +(0.4*$74.61)
+(0.3*$37.3)]/1.1 = $67.82.
See Ch 15 Mini Case.xls for calculations.
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 40
The Input for P in the Black-Scholes
Model
The input for price is the present
value of the project’s expected future
cash flows.
Based on the previous slides,
P = $67.82.
Judgment.
The direct approach, using the
results from the scenarios.
The indirect approach, using the
expected distribution of the project’s
value.
$111.91 65.0%
High
$67.82 Average $74.61 10.0%
Low
$37.30 -45.0%
Example: 65.0% = ($111.91- $67.82) / $67.82.
See Ch 15 Mini Case.xls for calculations.
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 46
Use these scenarios, with their given
probabilities, to find the expected
return and variance of return.
E(Ret.)=0.3(0.65)+0.4(0.10)+0.3(-0.45)
E(Ret.)= 0.10 = 10%.
σ 2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2
+ 0.3(-0.45-0.10)2
σ 2 = 0.182 = 18.2%.
$111.91
High
Average $74.61
Low
$37.30
E(PV)=.3($111.91)+.4($74.61)+.3($37.3)
E(PV)= $74.61.
σ PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
σ PV = $28.90.
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 52
Find the project’s expected coefficient
of variation, CVPV, at the time the option
expires.
2
ln[0.39 + 1]
2
σ = =14.2%
1
V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].
ln($67.83/$70)+[(0.06 + 0.142/2)](1)
d1 =
(0.142)0.5 (1).05
= 0.2641.
d2 = d1 - (0.142)0.5 (1).05= d1 - 0.3768
= 0.2641 - 0.3768 =- 0.1127.
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15 - 56
V = $67.83(0.6041) - $70e-0.06(0.4551)
= $40.98 - $70(0.9418)(0.4551)
= $10.98.
Note: Values of N(di) obtained from Excel using
NORMSDIST function. See Ch 15 Mini Case.xls for details.
$111.91
High
$56.05 Average $74.61
Low
$37.30
$111.91 25.9%
High
$56.05 Average $74.61 10.0%
Low
$37.30 -12.7%
Example: 25.9% = ($111.91/$56.05)(1/3) - 1.
See Ch 15 Mini Case.xls for calculations.
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 69
Use these scenarios, with their given
probabilities, to find the expected
return and variance of return.
E(Ret.)=0.3(0.259)+0.4(0.10)+0.3(-0.127)
E(Ret.)= 0.080 = 8.0%.
σ 2 = 0.3(0.259-0.08)2 + 0.4(0.10-0.08)2
+ 0.3(-0.1275-0.08)2
σ 2 = 0.023 = 2.3%.
$111.91
High
Average $74.61
Low
$37.30
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 72
Use these scenarios, with their given
probabilities, to find the project’s
expected PV and σ PV.
E(PV)=.3($111.91)+.4($74.61)+.3($37.3)
E(PV)= $74.61.
σ PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
σ PV = $28.90.
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15 - 73
Now use the indirect formula to
estimate σ 2.
CVPV = $28.90 /$74.61 = 0.39.
The option expires in 3 years, t=3.
2
ln[0.39 + 1]
2
σ = = 4.7%
3
V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].
ln($56.06/$75)+[(0.06 + 0.047/2)](3)
d1 =
(0.047)0.5 (3).05
= -0.1085.
d2 = d1 - (0.047)0.5 (3).05= d1 - 0.3755
= -0.1085 - 0.3755 =- 0.4840.
Copyright © 2002 Harcourt Inc. All rights reserved.
15 - 75
V = $56.06(0.4568) - $75e(-0.06)(3)(0.3142)
= $5.92.