OUTLINE

• Terminology
• Option Payoffs

• Factors Determining Option Values

• Binomial Model

• Black-Scholes Model

• An Application

 Centre for Financial Management , Bangalore

 LIMITS OF DCF ANALYSIS
SECURITIES CORPORATE ANALOGS
1. DCF .. STANDARD BONDS 1. DCF . . VALUE SAFE FLOWS
2. DCF .. SENSIBLE … SAFE (LEASES)
STOCKS .. REGULAR DIVIDENDS 2. DCF … CASH COWS, ENGG. REPLACE’T
 LIMITS OF DCF ANALYSIS
SECURITIES CORPORATE ANALOGS

3. DCF . . NOT VERY HELPFUL . .

VALUING STOCKS … 3. DCF . . LESS HELPFUL . .
SIGNIFICANT GROWTH VALUING BUSINESSES
OPPORTUNITIES SUBSTANTIAL GROWTH
OPP … OR INTANGIBLE ASSETS
4. DCF . . NEVER USED FOR 4. DCF . . NO HELP … FOR PURE
TRADED CALLS R & D PROJECTS
 EXAMPLES OF REAL OPTION ANALYSIS

At Merck, R& D projects are



analysed in the real options

framework. An R&D project
involves staged investments (which
depend on the outcomes in previous
stages) and hence is eminently
suitable for real options analysis.

 OPTIONS
BUYER/HOLDER SELLER/WRITER

RIGHTS/ BUYERS HAVE RIGHTS- SELLERS HAVE ONLY

OBLIGATIONS NO OBLIGATIONS OBLIGATIONS-NO RIGHTS
CALL RIGHT TO BUY/TO GO OBLIGATION TO SELL/GO
LONG SHORT ON EXERCISE
PUT RIGHT TO SELL/ TO OBLIGATION TO BUY/GO
GO SHORT LONG ON EXERCISE
PREMIUM PAID RECEIVED
EXERCISE BUYER’S DECISION SELLER CANNOT
INFLUENCE
MAX. LOSS COST OF PREMUIM UNLIMITED LOSSES
POSSIBLE
MAX. GAIN UNLIMITED PROFITS PRICE OF PREMIUM
POSSIBLE
CLOSING • EXERCISE • ASSIGNMENT OF OPTION
POSITION OF • OFFSET BY SELLING • OFFSET BY BUYING BACK
EXCHANGE OPTION IN MARKET OPTION IN MARKET
TRADED • LET OPTION EXPIRE • OPTION EXPIRES AND KEEP
OPTIONS WORTHLESS THE FULL PREMIUM
 Options
Buyer/Holder Seller/Writer

Rights/ Buyers have rights- Sellers have only

Obligations NO OBLIGATIONS Obligations-No Rights
Call Right to buy/to go long Obligation to sell/go short on
exercise
Put Right to sell/ to go short Obligation to buy/go
long on
exercise
Premium Paid Received
Exercise Buyer’s decision Seller cannot influence

Max. Loss Cost of premium Unlimited losses

possible
Max. Gain Unlimited profits Price of premium
possible
Closing • Exercise • Assignment on option
position of • Offset by selling • Offset by buying back
exchange option in market option in market
traded • Let option lapse • Option expires and keep
worthless the full premium
 OPTION PAYOFFS :BUYER
Payoff of a Call Option

Payoff of a
Call Option

E (Exercise Price) Stock Price

Payoff of a Put Option

Payoff of a
Put Option

E (Exercise Price) Stock Price

PAYOFFS TO THE SELLER OF OPTIONS
Payoff

E
Stock Price

(A) Sell A Call

Payoff

E
Stock Price

(B) Sell a Put

 OPTION VALUE : BOUNDS
UPPER AND LOWER BOUNDS FOR THE VALUE OF CALL OPTION

Value of Upper Lower

Call Option Bound ( S ) Bound ( S0 –E )
0

Stock Price
0 E
FACTORS DETERMINING THE OPTION
VALUE

• Exercise Price

• Expiration Date

• Stock Price

• Stock Price Variability

• Interest Rate
C0 = F [S0 , E, 2, T , Rf ]
+ - + + +
 Variability and Call Option Value
So fundamental is this point that it calls for another illustration.
Consider the probability distribution of the price of two stocks, P and Q,
just before the call option (with an exercise price of 80) on them expires.

P Q
Price Probability Price Probability
60 0.5 50 0.5
80 0.5 90 0.5

While the expected price of stock Q is same as that of stock P, the variance
of Q is higher than that of P. The call option (exercise price: 80) on stock P
is worthless as there is no likelihood that the price of stock P will exceed
80. However, the call option on stock Q is valuable because there is a
distinct possibility that the stock price will exceed the exercise price.
 Variability and Call Option Value

Basic difference .. holding a stock.. holding a call

option on the stock.
A risk-averse investor ..shuns.. high variance stock.
However, likes .. buy a call option on that stock
Thus, regardless of your risk disposition, you will
find a high variance in the underlying stock
desirable.
 Basic Idea
The standard DCF (discounted cash flow) .. two
steps, viz. estimation of expected future cash flows
and discounting .. cash flows .. cost of capital.

There are in applying this procedure to option

valuation.
While it is difficult (though feasible) to estimate
expected cash flows,
it is impossible to determine . cost of capital
because .. risk of an option is virtually
indeterminate as it changes every time the stock
price varies.
 Basic Idea
Since options cannot be valued by the standard DCF method,
financial economists struggled to develop a rigorous method for
valuing options for many years.

Finally, a real breakthrough .. Fisher Black and Myron Scholes..

published their famous model in 1973.

The basic idea .. portfolio which imitates the call option in its payoff.

The cost of such a portfolio, which is readily observed, must

represent the value of the call option.

The key insight underlying the Black and Scholes model may be
illustrated through a single-period binomial (or two-state) model.
 BINOMIAL MODEL
OPTION EQUIVALENT METHOD

A single period Binomial (or 2 - State) Model

• S can take two possible values next year, uS or dS (uS > dS)
• B can be borrowed .. or lent at a rate of r, the risk-free rate..
(1 + r) = R
• d < R < u
• E is the exercise price
Cu = Max (u S - E, 0)
Cd = Max (dS - E, 0)
BINOMIAL MODEL :OPTION EQUIVALENT
Portfolio
 Shares of the stock and B rupees of borrowing
Stock price rises :  uS - RB = Cu
Stock price falls :  dS - RB = Cd
Cu - Cd Spread of possible option price
 = =
S (u- d) Spread of possible share prices
dCu - uCd
B =
(u - d) R
Since the portfolio (consisting of  shares and B debt) has the same
payoff as that of a call option, the value of the call option is
C = S - B
 ILLUSTRATION
S = 200, u = 1.4, d = 0.9
E = 220, r = 0.10, R = 1.10
Cu = Max (u S - E, 0) = Max (280 - 220, 0) = 60
Cd = Max (dS - E, 0) = Max (180 - 220, 0) = 0
Cu - Cd 60
 = ---------- = ----------- = 0.6
(u - d) S 0.5 (200)
dCu - uCd 0.9 (60)
B = ---------- = ----------- = 98.18
(u - d) R 0.5 (1.10)
0.6 of a share + 98.18 borrowing … 98.18 (1.10) = 108 repayt
Portfolio Call Option
When u occurs 1.4 x 200 x 0.6 - 108 = 60 Cu = 60
When d occurs 0.9 x 200 x 0.6 - 108 = 0 Cd = 0
C =  S - B = 0.6 x 200 - 98.18 = 21.82
 BLACK - SCHOLES MODEL
E
C0 = S0 N (d1) - N (d2)
ert
N (d) = Value of the cum. standard normal density function
S0
ln E + ( r + 1/ 2 2 ) t
d1 =
t
d2 = d1 -   t
r = continously compounded risk- free annual interest rate

t = time to expiration in years

 = standard deviation of the continuosly compounded
annual rate of return on the stock asset
 BLACK - SCHOLES MODEL
ILLUSTRATION
S0 = RS.60 E = RS.56  = 0.30
t = 0.5 r = 0.14
STEP 1 : CALCULATE d1 AND d2
S0 2
ln E + r + 2 t
d1 =
t
.068 993 + 0.0925
= = 0.7614
0.2121
d2 = d1 -   t
= 0.7614 - 0.2121 = 0.5493
STEP 2 : N (d1) = N (0.7614) = 0.7768 NORMSDIST
N (d2) = N (0.5493) = 0.7086
STEP 3 : E 56
= = RS. 52.21
ert
e0.14 x 0.5

STEP 4 : C0 = RS. 60 x 0.7768 - RS. 52.21 x 0.7086

= 46.61 - 37.00 = 9.61
 Centre for Financial Management , Bangalore
 Step 2: Finding N(d1) and N (d2)
The simplest way to find N(d1) and N(d2) is to use the Excel function
NORMSDIST.
N(d1) = N (0.7614) = 0.7768
N(d2) = N (0.5493) = 0.7086
If you don’t have easy access to the excel function NORMSDIST, you can get a
very close approximation by using the Normal Distribution given in Table A.5 in
Appendix A at the end of the book. The procedure for doing that may be
illustrated with respect to N (0.7614) as follows
 TYPES OF REAL OPTIONS

• Investment timing options

• Growth options
• Flexibility options
• Abandonment options
VALUE .. OPTION .. MAKE A FOLLOW ON
INVESTMENT
• Electriad – II … Double .. Size of
Electriad - I … Investment : Rs. 300 M
• Cash inflows … twice .. PV of Rs. 265 m … year 4
•  = 0.4
S0 = 265 x e - 0.12 x 4 = Rs. 163.98 Million
E = Rs. 300 M
 = 0.4
t = 4
r = 12 Percent
Step 1 : Calculate d 1 and d 2

S0 s2
ln + r+ t
E 2 - 0.844 + (.12 + (.16/2)) 4
d1 = = = -.055
s Öt 0.4 Ö4

d2 = d1 - s Ö t = - 0.855

Step 2 : Find N (d 1 ) and N (d2 )

N(d1) = 0.4781
N(d2) = 0.1963
Step 3 : Estimate the Present Value of the Exercise Price
E . e-rt = 300 / 1.6161 = RS.185.63 Million

Step 4 : Plug the numbers obtained in the previous steps in the

Black-Scholes formula

C0 = Rs.163.98 Million x 0.4781 – Rs.185.63 Million x 0.1963

= Rs.78.40 Million – Rs.36.44 Million = Rs.41.96 Million
VALUE OF A NATURAL RESOURCE OPTION

• Value of the available reserves of the resource

• Development cost
• Time to expiration of the option
• Variance in value of the underlying asset
• Cost of delay… like dividend yield in a stock loss of
prod’n … each year of delay …
• Development lag
 LONG - TERM OPTIONS

C = S e - y t N (d1) - E e - r t N (d2)

S s2
ln + r-y + t
E 2
d1 =
s Öt

d2 = d1 - s Ö t
 ILLUSTRATION

• Estimated oil reserve : 100 million barrels

• Development cost : $ 1 billion
• Right : 25 years
• Marginal value per barrel : $ 20
•  of ln (Oil Price) = 0.2
• Net prod’n revenue annual = 4% of value of reserve
• r = 8%
• Development lag = 2 years
 ILLUSTRATION
• Estimated oil reserve : 100 million barrel
• Marginal value per barrel : $ 20
• Development lag : 2 years
• Dividend yield : 4%
S0 = Current value of the asset
$ 20 x 100
= = $ 1849.11 million
(1.04)2
E = Development cost = $ 1000 million
 = 0.2
t = Life of the option = 25 yrs
r = 8%
Net Prod’n Revenue
y = = 4%
Value of Reserve
STEP 1: CALCULATE d1 AND d2

S 2
d1 = ln + r–y + t
E 2
 t
= ln (1849.11 / 1000) + [.08 - .04 + (.04/2)] 25 ÷0.2 25
= 0.6147 + 1.5 = 2.1147
d2 = d1 -  t

= 2.1147 – 1.000 = 1.1147

STEP 2: FIND N(d1) AND N(d2)
N(d1) = N (2.1147) = 0.9828
N(d2) = N (1.1147) = 0.8675
STEP 3: ESTIMATE THE PRESENT VALUE OF THE EXERCISE PRICE
E / en = 1000 / e.08 x 25 = $ 135.33 MILLION

STEP 4: PLUG THE NUMBERS OBTAINED IN THE PREVIOUS STEPS

IN THE BLACK-SCHOLES FORMULA

C = $1849.11 MILLION x 0.9828 - $ 135.33 MILLION x 0.8675

= $1699.91 MILLION
 Relative values of Cash Flows and Options

L
o Cash flows : 75 Cash flows : 75
n Options : 25 Options : 25
g
Duration of
the Project
S
h Cash flows : 95 Cash flows : 75
o Options : 5 Options : 25
r
t
Low High
Environmental Uncertainty