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Option Pricing With Applications To Real Options
Option Pricing With Applications To Real Options
CHAPTER 17
Option Pricing with Applications to
Real Options
Financial options
Black-Scholes Option Pricing Model
Real options
Decision trees
Application of financial options to
real options
17 - 2
What is a real option?
Option Terminology
Table (Continued)
5
Exercise value
5 10 15 20 25 30 35 40 45 50
Stock Price
17 - 13
V = P[N(d1)] - Xe -r t[N(d2)].
RF
V = $27(0.7168) - $25e-0.03(0.6327)
= $19.3536 - $25(0.97045)(0.6327)
= $4.0036.
17 - 19
(More...)
17 - 22
Abandonment options
Contraction
Temporary suspension
Flexibility options
17 - 25
Five Procedures for Valuing
Real Options
1. DCF analysis of expected cash flows,
ignoring the option.
2. Qualitative assessment of the real
options value.
3. Decision tree analysis.
4. Standard model for a corresponding
financial option.
5. Financial engineering techniques.
17 - 26
E(NPV) = [0.3($35.70)]+[0.4($1.79)]
+ [0.3 ($0)]
E(NPV) = $11.42.
17 - 33
Decision Tree with Option to Wait vs.
Original DCF Analysis
Decision tree NPV is higher ($11.42
million vs. $4.61).
In other words, the option to wait is
worth $11.42 million. If we implement
project today, we gain $4.61 million but
lose the option worth $11.42 million.
Therefore, we should wait and decide
next year whether to implement
project, based on demand.
17 - 34
The Option to Wait Changes Risk
The cash flows are less risky under the
option to wait, since we can avoid the
low cash flows. Also, the cost to
implement may not be risk-free.
Given the change in risk, perhaps we
should use different rates to discount
the cash flows.
But finance theory doesnt tell us how to
estimate the right discount rates, so we
normally do sensitivity analysis using a
range of different rates.
17 - 35
Procedure 4: Use the existing model
of a financial option.
The option to wait resembles a
financial call option-- we get to buy
the project for $70 million in one year
if value of project in one year is
greater than $70 million.
This is like a call option with an
exercise price of $70 million and an
expiration date of one year.
17 - 36
Inputs to Black-Scholes Model for
Option to Wait
X = exercise price = cost to implement
project = $70 million.
rRF = risk-free rate = 6%.
t = time to maturity = 1 year.
P = current stock price = Estimated on
following slides.
2 = variance of stock return =
Estimated on following slides.
17 - 37
Estimate of P
For a financial option:
P = current price of stock = PV of all of
stocks expected future cash flows.
Current price is unaffected by the
exercise cost of the option.
For a real option:
P = PV of all of projects future
expected cash flows.
P does not include the projects cost.
17 - 38
Step 1: Find the PV of future CFs at
options exercise year.
Future Cash Flows PV at
2002 Prob. 2003 2004 2005 2006 2003
$111.91
High
$67.82 Average $74.61
Low
$37.30
PV2002=PV of Exp. PV2003 = [(0.3* $111.91) +(0.4*$74.61)
+(0.3*$37.3)]/1.1 = $67.82.
See Ch 17 Mini Case.xls for calculations.
17 - 40
The Input for P in the Black-Scholes
Model
The input for price is the present
value of the projects expected future
cash flows.
Based on the previous slides,
P = $67.82.
17 - 41
Estimating 2 for the Black-Scholes
Model
For a financial option, 2 is the
variance of the stocks rate of return.
For a real option, 2 is the variance of
the projects rate of return.
17 - 42
Judgment.
The direct approach, using the
results from the scenarios.
The indirect approach, using the
expected distribution of the projects
value.
17 - 43
$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 17 Mini Case.xls for calculations.
17 - 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%.
2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2
+ 0.3(-0.45-0.10)2
2 = 0.182 = 18.2%.
17 - 47
$111.91
High
Average $74.61
Low
$37.30
17 - 51
Use these scenarios, with their given
probabilities, to find the projects
expected PV and PV.
E(PV)=.3($111.91)+.4($74.61)+.3($37.3)
E(PV)= $74.61.
PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
PV = $28.90.
17 - 52
Find the projects expected coefficient
of variation, CVPV, at the time the option
expires.
ln[ 0.39 1]
2
2
14.2%
1
17 - 54
The Estimate of 2
Subjective estimate:
12% to 19%.
Direct estimate:
18.2%.
Indirect estimate:
14.2%
For this example, we chose 14.2%,
but we recommend doing sensitivity
analysis over a range of 2.
17 - 55
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.
17 - 56
V = $67.83(0.6041) - $70e-0.06(0.4551)
= $40.98 - $70(0.9418)(0.4551)
= $10.98.
E(NPV) = [0.3($36.91)]+[0.4(-$0.39)]
+ [0.3 (-$37.70)]
E(NPV) = -$0.39.
E(NPV) = [0.3($58.02)]+[0.4(-$0.39)]
+ [0.3 (-$37.70)]
E(NPV) = $5.94.
$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 17 Mini Case.xls for calculations.
17 - 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%.
2 = 0.3(0.259-0.08)2 + 0.4(0.10-0.08)2
+ 0.3(-0.1275-0.08)2
2 = 0.023 = 2.3%.
17 - 70
Why is 2 so much lower than in the
investment timing example?
2 has fallen, because the dispersion
of cash flows for replication is the
same as for the original project, even
though it begins three years later.
This means the rate of return for the
replication is less volatile.
We will do sensitivity analysis later.
17 - 71
Estimating 2 with the Indirect Method
From earlier slides, we know the
value of the project for each scenario
at the expiration date.
PV2005
$111.91
High
Average $74.61
Low
$37.30
17 - 72
Use these scenarios, with their given
probabilities, to find the projects
expected PV and PV.
E(PV)=.3($111.91)+.4($74.61)+.3($37.3)
E(PV)= $74.61.
PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
PV = $28.90.
17 - 73
Now use the indirect formula to
estimate 2.
CVPV = $28.90 /$74.61 = 0.39.
The option expires in 3 years, t=3.
ln[ 0.39 1]
2
2
4.7%
3
17 - 74
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.
17 - 75
V = $56.06(0.4568) - $75e(-0.06)(3)(0.3142)
= $5.92.