Real Option - FINA537 Equity Valuation Professor Laura...

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1FINA537 Equity ValuationProfessor Laura Xiaolei LiuReal Options
2What is Option?
3An Option ExampleCurrent stock price is $20, it may go up 10% to $22 with 80% probability next year, or go down 10% to $18 with 20% probability, risk free rate is 5%What is the value of a call option, which allows you to buy a stock next year at price $21?
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5Option example: Answer
6Understand the terminologyExercise price: (K) $21Maturity: (T) 1 yearStock price: (S) $20Volatility of underlying stock (σ, range of 22-18)Option type: ¾Call v.s. Put¾European v.s. American Option
7TerminologyIncrease %: u=22/20=1.1Decrease %: d=18/20=0.9Option value in good state: fu=1Option value in bad state: fd=0
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9Real Option – Option value P=(1+rf-d) ----Risk neutral probability(u-d)Option value = fu×P+fd×(1-P)(1+rf)
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11Two-step option value

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