Option Valuation

7 Key excerpts on "Option Valuation"

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  eBook - ePub

  Fair Value Measurements

  Practical Guidance and Implementation

  • Mark L. Zyla(Author)
  • 2009(Publication Date)
  • Wiley

    (Publisher)

  Although the application of options valuation techniques to assess the impact of managerial decision making is a relatively new topic in financial theory, its acceptance is becoming more widespread. The advantage of these methodologies is that they utilize models that more accurately reflect real-world decision making. Option pricing methodologies cannot only be used to quantify the additional value created by flexibility in decision making but they are useful tools for assessing the economic impact of contingent events. These techniques are applicable to the valuation of capital investments, specific tangible and intangible assets, to liabilities, and to the entity itself. Options valuation techniques are likely to assume a more prominent role in the measurement of fair value for financial reporting purposes in the future.

  Option Basics

  An option1 is a contract that gives the owner the right to buy (or sell) an underlying asset from (to) the counterparty to the contract, at a certain price over a certain period of time. The option contract creates a right but it does not impose any obligation to buy or sell the underlying asset. Calls and puts, described in the previous section, are the most common types of options. Options are considered derivative securities because the value of the option is derived from the value of the underlying asset. Options are also considered contingent claims because the value of the option is contingent on the underlying asset achieving a certain benchmark value. The benchmark value is known as the exercise price. If the underlying asset fails to meet the exercise price, the option is worthless. The value of financial options is derived from the market prices of the underlying financial instruments or securities.

  The value of an option is equal to the sum of its intrinsic value and its time value. The intrinsic value is equal to the difference between the price of the underlying share of stock and the exercise price of the option. Assume that an entity owns a call option on one share of PublicCo with an exercise price of $75 per share that expires in six months. If PublicCo is trading at $80 per share, then the intrinsic value of the call option is $5 per share. However, the intrinsic value is not necessarily the fair value of the option. If the option itself is publicly traded, then its fair value is most likely equal to the option’s market price. The fair value of the option may be greater than its intrinsic value. This is most often the case when the option has a significant length of time before its expiration date. The value in excess of the intrinsic value is due to the time value of the option.

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  eBook - ePub

  Fair Value Measurement

  Practical Guidance and Implementation

  • Mark L. Zyla(Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Advanced valuation techniques such as option‐pricing models can be used to estimate the fair value of certain intangible assets whose value is derived from, and therefore contingent on, actions by management. This methodology is sometimes referred to as a “real” option because the methodology measures the value resulting from specific operating decisions, rather than financial decisions. Real Option Valuation methods can be used to measure the fair value of certain intangible assets. Although the application of options valuation techniques to assess the impact of managerial decision making is a relatively new topic in financial theory, its acceptance is becoming more widespread. The advantage of these methodologies is that they utilize models that more accurately reflect real‐world decision making. Option pricing methodologies cannot only be used to quantify the additional value created from flexibility in decision making but they are useful tools for assessing the economic impact of contingent events. These techniques are applicable to the valuation of capital investments, specific tangible and intangible assets, to liabilities, and to the entity itself. Options valuation techniques are likely to assume a more prominent role in the measurement of fair value for financial reporting purposes in the future. Option Basics An option 1 is a contract that gives the owner the right to buy (or sell) an underlying asset from (to) the counterparty to the contract, at a certain price over a certain period of time. The option contract creates a right but it does not impose any obligation to buy or sell the underlying asset. Calls and puts, described in the previous section, are the most common types of options. Options are considered derivative securities because the value of the option is derived from the value of the underlying asset

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  Understanding Investments

  Theories and Strategies

  • Nikiforos T. Laopodis(Author)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  Lessons of Our Times to find out more about the dangers of derivatives trading when bets go wrong. In addition, you will learn of the activities of some famous rogue traders who brought down banks and lost billions of dollars for the banks they were working for. The relevant question is then: Why do excessive speculation and fraud still exist in huge, international banks that result in multibillion-dollar losses?

  14.4 Option Valuation

  Thus far, we have presented the basics of options and discussed some strategies regarding them. Throughout our discussion, the prices of these derivative products were taken as given. In this section, we will show how to price some products and discuss the factors that affect their prices. To be fair, valuation of options is very complex and for that reason we will only present here some basic notions and the two, most important Option Valuation models. We begin with the fundamentals of Option Valuation models and continue with their corresponding mathematical models, the binomial and the Black-Scholes-Merton Option Valuation models.

  14.4.1 Fundamental Option Valuation concepts

  We discussed the two basic option concepts, the underlying asset’s price, ST , and the strike (or exercise) price, X. The difference (or relationship) between the two defines the gross profit or loss from the option, on or before expiration. For example, if ST – X is negative (ST < X), the option might be out of the money before expiration, but this does not mean that the option is valueless! There is still a chance that things may turn around and make the option valued (the worst outcome would be a zero value for the option at expiration). This difference is known as the option’s intrinsic value

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  The Economics of Business Valuation

  Towards a Value Functional Approach

  • Patrick Anderson(Author)
  • 2013(Publication Date)
  • Stanford Economics and Finance

    (Publisher)

  options to make further investments on possibly favorable terms. This value depends on the rule for deciding whether the options are to be exercised. (Myers, 1977, pp. 148–149; emphasis in original)

  This idiosyncrasy concerns not just the risks the company faces, but also what we call the “policy” the firm follows in the value functional approach described in Chapter 17 , “Applications: Finance and Valuation.”

  Caution on Separating Real Options from the Business

  One must be careful to not assume that a valuable, incremental real option exists in a business when the exercise (or refusal to exercise) of that option is already embedded in the general operation of business. Because real options are usually idiosyncratic and related to the firm’s operations in some manner, the distinction is not easy to draw.

  Similarly, failing to take into account the consequences of exercising a real option—or counting them twice—can cause major errors in valuation. One must consider whether the management and financiers of a firm are willing to support the exercise of options, as well as bear their cost, before simply adding the value of a real option to the current-operations value of the firm. We return to this issue below.

  REAL Option Valuation: METHODS

  The Need for Robust Option Valuation Tools

  The search for the price of a pure financial option, under ideal conditions, took more than a century. There are now plenty of analytical models that, for a variety of standard financial options, can quickly provide an estimate of market prices (usually under strict assumptions). However, we are still looking for a truly robust valuation tool that will estimate the market value of real options. Next, we outline a dozen methods in a handful of categories and provide some practical comments on the applicability of each.

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  Applied Mergers and Acquisitions

  • Robert F. Bruner(Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 10 Valuing Options

  OVERVIEW

  The world of M&A has been influenced greatly by options concepts; in addition, these concepts help explain behavior and deal features that were previously difficult to understand. Options concepts surface in many chapters in this book simply because of their explanatory force. This chapter provides a conceptual foundation for the discussions in other chapters as it:

  • Surveys the determinants of an option’s value.
  • Considers models of an option’s value.
  • Illustrates the practical valuation of financial options.
  • Suggests how option pricing theory may be used to value securities as different as loan guarantees, bonds, and common stock.
  • Points you toward further study in this area. This chapter is intended to be a summary rather than a detailed exposition of theories.

  Option pricing theory is highly relevant to the field of mergers and acquisitions for three main reasons:

  1. Valuation of firms. As discussed in Chapter 9 , DCF and other estimation approaches probably do not capture the option value present in assets and enterprises. Option Valuation may be an important supplement, therefore, to these other approaches.
  2. Options’ value, even if deep out of the money. Options are more valuable the longer the life of the option and the greater the uncertainty about future value. The implication of this is that the valuation approaches discussed earlier may under- or overestimate the value of a target firm. One of the limitations of discounted cash flow is that it does not capture well the strategic aspects of capital investment. Such strategic elements include the right to make future investments, the right to sell or liquidate in the future, the right to abandon, and the right to switch investments.
  3. Pervasiveness of options.

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  Investment Valuation

  Tools and Techniques for Determining the Value of any Asset, University Edition

  • Aswath Damodaran(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Consider, for instance, the option to expand a project that is discussed in Chapter 30. While we will value this option using a simple option pricing model, in reality there could be multiple stages in expansion, with each stage representing an option for the following stage. In this case, we will undervalue the option by considering it as a simple rather than a compound option.

  Notwithstanding this discussion, the valuation of compound options becomes progressively more difficult as more options are added to the chain. In this case, rather than wreck the valuation on the shoals of estimation error, it may be better to accept the conservative estimate that is provided with a simple valuation model as a floor on the value.

  Rainbow Options

  In a simple option, the uncertainty is about the price of the underlying asset. Some options are exposed to two or more sources of uncertainty, and these options are rainbow options. Using the simple option pricing model to value such options can lead to biased estimates of value. As an example, consider an undeveloped oil reserve as an option, where the firm that owns the reserve has the right to develop the reserve. Here there are two sources of uncertainty. The first is obviously the price of oil, and the second is the quantity of oil that is in the reserve. To value this undeveloped reserve, we can make the simplifying assumption that we know the quantity of oil in the reserve with certainty. In reality, however, uncertainty about the quantity will affect the value of this option and make the decision to exercise more difficult.4

  CONCLUSION

  An option is an asset with payoffs that are contingent on the value of an underlying asset. A call option provides its holder with the right to buy the underlying asset at a fixed price, whereas a put option provides its holder with the right to sell at a fixed price, at any time before the expiration of the option. The value of an option is determined by six variables—the current value of the underlying asset, the variance in this value, the expected dividends on the asset, the strike price and life of the option, and the riskless interest rate. This is illustrated in both the binomial and the Black-Scholes models, which value options by creating replicating portfolios composed of the underlying asset and riskless lending or borrowing. These models can be used to value assets that have option like characteristics.

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  eBook - ePub

  Economic Systems Analysis and Assessment

  Intensive Systems, Organizations,and Enterprises

  • Andrew P. Sage, William B. Rouse(Authors)
  • 2011(Publication Date)
  • Wiley-Interscience

    (Publisher)

  In summary, the OV increases with projected cash flows should one exercise the option, uncertainty (volatility) associated with these cash flows, and time until the decision to exercise it need be made. It may seem unusual that uncertainty and time increase value, but the key point is that they increase the OV on a future that may not materialize. That is exactly why one prefers to own an option.

  9.2 OPTION PRICING THEORY

  The question we address here is how to estimate or assess the economic OV on uncertain future cash flows that may or not be realized. Black and Scholes (1973) addressed this by envisioning a “replicating portfolio” that consists of some number of owned shares of stock and borrowed capital with interest paid at the risk-free rate. This replicating portfolio will have the same payoff as the call option at expiration and therefore, by the fundamental theorem of finance, the portfolio value must equal the call option value. They constructed this portfolio to be entirely self-financing and thus deterministic.

  This conceptual insight led them (Black and Scholes, 1973), with contributions from Merton (1973), to derive the now-famous Black–Scholes equation starting with

  (9.1)

  (9.2)

  where S is the price of the underlying security, z is a standard Brownian motion or Wiener process over [0, T ], and B is the value of a risk-free bond carrying an interest rate of r over [0, T ].

  The stochastic process employed to represent the time variation of stock prices is often referred to as geometric Brownian motion or exponential Brownian motion where the logarithm of the random variable follows a Brownian motion process. It is commonly used as an approximation of stock price dynamics. µ is termed the percentage drift and σ the percentage volatility, and both values are assumed constant.

  An important implication of assuming geometric Brownian motion is the lognormality of the random value, which means that the probability distribution of the variable is skewed and cannot take on negative values. This is appropriate because negative asset values will result in an option not being exercised as the value of the option is zero. Thus, and again essentially by definition, options are only exercised when they are “in the money.” Otherwise, they are discarded.

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