06 - Valution of Derivitives

06 - Valution of Derivitives - Venture Capital & Private...

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Venture Capital & Private Equity Valuing Derivative Securities Primer on: A Primer on: Options Pricing & Other Derivative Securities Professor David Wessels © 2008 The Wharton School of the University of Pennsylvania 3620 Locust Walk, Philadelphia PA 19104
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Venture Capital & Private Equity Valuing Derivative Securities Derivatives / Contingent Claims this lecture, we focus on traditional In this lecture, we focus on traditional valuation techniques for contingent claims. Payoff Diagram for a Traditional Call Option These valuation techniques were pioneered by Black, Merton, and Scholes during the early 1970s. 8 10 12 n Payof f The valuation of contingent claims (such as options and other derivatives) is unique because it does not rely on 0 2 4 6 Call Optio probability assessments , nor the company’s cost of capital . 0 3 6 9 15 18 21 24 27 30 Enterprise Value (in $millions) Professor David Wessels The Wharton School of the University of Pennsylvania 2
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Venture Capital & Private Equity Valuing Derivative Securities Venture Capital & Contingent Claims To value the enterprise, we use traditional valuation techniques such as discounted free cash ow (using probabilities) or Exit Diagram for Redeemable Convertible Preferred flow (using probabilities) or multiples. Because the payoff structures in 8 10 12 ock Payo f venture capital are not simply linear functions of enterprise alue, we need to use options 0 2 4 6 Preferred St o value, we need to use options models to convert enterprise value into preferred stock value. 0 3 6 9 15 1 8 21 24 27 30 Enterprise Value Professor David Wessels The Wharton School of the University of Pennsylvania 3
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Venture Capital & Private Equity Valuing Derivative Securities Contingent Claims Valuation: Binomial Trees Let’s value a contingent claim in he Underlying Asset a one period, two state world. For exposition, we start with a two state model and then ? The Underlying Asset S 1 = 130 generalize. What is the value of a stock that n either rise to $130 or fall to S 0 = ? S 1 = 90 can either rise to $130 or fall to $90 with equal probability? The cost of equity equals 10% The Contingent Claim C 1 = max(S 1 -K , ±0) ±= ± What are the payoffs for a call option with a strike price (K) of $100? C 0 = ? C 2 = max(S 1 , Professor David Wessels The Wharton School of the University of Pennsylvania 4
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Venture Capital & Private Equity Valuing Derivative Securities The Replicating Portfolio: An Example To value the call option, we can not use discounted cash flow , as we do not know the appropriate cost of capital for an option. Therefore, we use replicating portfolios. ince there are two states of the world we need two assets to replicate the Since there are two states of the world, we need two assets to replicate the payoff structure of the call option. As the second asset, we use a risk free bond.
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This note was uploaded on 09/08/2008 for the course FNCE 750 taught by Professor Wessels during the Spring '08 term at UPenn.

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06 - Valution of Derivitives - Venture Capital & Private...

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