BasicsOPT&RO - Basics of Option Pricing Theory And...

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- 1 - Basics of Option Pricing Theory And Applications in Financial Decision Making - 2 - What are the Value Drivers? Market value of physical assets Consider change in net worth when new assets and liabilities are included in the balance sheet When would impact on net worth be neutral? … Negative? … Positive? You may be able to stop here if neutral or positive Added earning power derived from new assets DCF methods focus on these earnings You may be able to stop here, too Option approaches continue from here Value of new opportunities Enhanced value of human capital Stronger organizational capital via enhanced flexibility New incentives offered to key decision makers Enhanced technology Enhanced competitive advantage
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- 3 - What are financial options? Options are financial contracts whose value is contingent upon the value of some underlying asset Such arrangements are also known as contingent claims because equilibrium market value of an option moves in direct association with the market value of its underlying asset. OPT measures this linkage - 4 - The basics of options Calls and puts defined Call: privilege of buying the underlying asset at a specified price and time Put: privilege of selling the underlying asset at a specified price and time
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- 5 - The basics of options Regional differences defined American options can be exercised anytime before expiration date European options can be exercised only on the expiration date Asian options are settled based on average price of underlying asset - 6 - The basics of options Options may be allowed to expire without exercising them Options game has a long history at least as old as the “premium game” of 17th century Amsterdam developed from an even older “time game” which evolved into modern futures markets and spawned modern central banks
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- 7 - How are Real Options Different? Financial Options Underlying assets are financial assets Rules governing exercise are stated in contract Real Options Underlying assets are physical items Rules governing exercise reflect realities in the physical realm - 8 - Option Applications Growth options See Black/Scholes (1973), Myers (1977) Options to abandon See Kensinger (1980), Myers & Majd (1984) Options to shut down temporarily See McDonald and Siegel (1985) See Brennan & Schwartz (1985) See Siegle, Smith, & Paddock (1988)
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- 9 - Option Applications Options to choose the most profitable of several activities See Chen, Conover, and Kensinger (1998) Strategic Options See Grinblatt & Titman (1998) See Luerhman (1998) Amram & Kulatilaka (2000) - 10 - Score Card DCF significantly underestimates value by ignoring real options RO also underestimates value RO doesn’t cover important parts of the value chain
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- 11 - The physical value chain from a global perspective:How much of it have we covered so far?
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This note was uploaded on 04/15/2011 for the course FINA 5220 taught by Professor Staff during the Spring '08 term at North Texas.

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BasicsOPT&RO - Basics of Option Pricing Theory And...

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