Basics of Option Pricing
Theory
And Applications in Financial Decision
Making
-1-
What are the Value
Drivers?
F Market value of physical
assets
l
l
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
F Added earning power
derived from new assets
l
l
F Option approaches continue from
here
l
l
Value of new opportunities
Enhanced value of human capital
— Stronger organizational capital
via enhanced flexibility
— New incentives offered to key
decision makers
l
l
Enhanced technology
Enhanced competitive advantage
DCF methods focus on these
earnings
You may be able to stop here, too
-2-
What are financial options?
F Options are financial contracts whose value is
contingent upon the value of some underlying asset
F Such arrangements are also known as contingent
claims
l because equilibrium market value of an option
moves in direct association with the market value of
its underlying asset.
F OPT measures this linkage
-3-
The basics of options
Calls and puts defined
F Call: privilege of buying the underlying asset at
a specified price and time
F Put: privilege of selling the underlying asset at
a specified price and time
-4-
The basics of options
Regional differences defined
F American options can be exercised anytime
before expiration date
F European options can be exercised only on the
expiration date
F Asian options are settled based on average
price of underlying asset
-5-
The basics of options
F Options may be allowed to expire without
exercising them
F Options game has a long history
l at least as old as the “premium game” of
17th century Amsterdam
l developed from an even older “time game”
—which evolved into modern futures markets
—and spawned modern central banks
-6-
How are Real
Options Different?
FFinancial Options
assets
are financial assets
FReal Options
l Underlying
l Underlying
l Rules
l Rules
governing
exercise are stated
in contract
assets
are physical items
governing
exercise reflect
realities in the
physical realm
-7-
Option Applications
F
Growth options
l See
F
Options to abandon
l See
F
Black/Scholes (1973), Myers (1977)
Kensinger (1980), Myers & Majd (1984)
Options to shut down temporarily
l See
McDonald and Siegel (1985)
l See Brennan & Schwartz (1985)
l See Siegle, Smith, & Paddock (1988)
-8-
Option Applications
F
Options to choose the most profitable of
several activities
l See
F
Chen, Conover, and Kensinger (1998)
Strategic Options
l See
Grinblatt & Titman (1998)
l See Luerhman (1998)
l Amram & Kulatilaka (2000)
-9-
Score Card
FDCF significantly underestimates value
by ignoring real options
FRO also underestimates value
FRO doesn’t cover important parts of the
value chain
- 10 -
The physical value chain from a global
perspective:How much of it have we
covered so far?
Support Activities:
•Technology Development
•Human Resources
Development
Service
Distribution&
Marketing
Fabrication
Refining
Basic Extraction
Physical
Realm
Value Added at
Each Step
- 11 -
Score Card
FVirtual option analysis helps fill the gap
even further
- 12 -
How are Virtual
Options Different?
F Real Options
F Virtual Options
l
Underlying assets are
physical items
l
Rules governing exercise
reflect realities in the
physical realm
l
Underlying assets are
information items
l
Rules governing exercise
reflect realities in the
information realm
- 13 -
Transition-Phase
Virtual Options
FDerive from information products
FUnderlying assets are real options
- 14 -
Virtual Value Chain &
Information Operations
GATHER AND APPLY IN THE PHYSICAL REALM
STORE AND TRANSFORM IN THE INFORMATION REALM
APPLY
PRESENT
DISTRIBUTE
SYNTHESIZE
Infosphere
SELECT
ORGANIZE
GATHER
- 15 -
Forging Links Between Finance
and Strategy
More Exploration of the Real
Options Frontier
- 16 -
Is there a conflict?
Competitive Advantage vs. Shareholder Value
F Why do people think there is conflict here?
F Why are managers frustrated with the market?
F Short Term vs. Long Term?
l
Is the market myopic?
F How long can value-creation last?
l
Are managers unrealistically optimistic about value
growth duration?
- 17 -
Common Link
F Productivity is foundation for competitive advantage
l
l
l
Value of output per unit of labor or capital
Superior value or lower cost for customers
A company creates competitive advantage when the long-term
value of output is greater than total costs (including cost of
capital)
F Foundation of share price is long-term forecast of
productivity
- 18 -
Reminder
F It isn’t enough to win
l
You have to do better than
expected
F Losing may not be bad
l
If you don’t do as badly as
expected
F Consistent performance
l
Makes flat stock price
- 19 -
Management Myths
F Market does not actually value long-term
productivity of my company, but judges it only
on short-term performance
F We here at this company must depart from the
shareholder-value model in order to improve
our competitive advantage
- 20 -
Market sees long-term
F Evidence concerning stock price reaction to capital expenditure
announcements
l
l
Positive for increases in spending, negative for decreases
Reverse response for oil exploration in the U.S. (data from 1980s)
F Evidence concerning expenditures for R&D
l
l
Positive for high-tech
Zero or negative for low-tech
F Strategic announcements
l
l
Stategic Alliance study
Woolridge (1988)
F Value decomposition studies
l
l
Woolridge (1995)
Alcar Group
- 21 -
PVGO
- 22 -
Appropriate Considerations
F Proper application of shareholder value
analysis requires careful consideration of
l Decision to invest new resources
l Decision not to invest
F The hazard of incorrect choice in the first case
is clear
F The hazard of incorrect choice in the second
case is that good opportunities might be lost to
competitors
- 23 -
Lesson from History
F A company that provides more "value" than investors
or customers want to pay for is not competitive, and
may not even be viable
l Lesson of Italian weavers in 17th century
l Lesson of Wallace Company, Houston
—Won Malcolm Baldrige National Quality Award in 1990
—Customers unwilling to pay increased prices
—Company soon began losing money, laying off employees,
and finally sought bankruptcy protection
- 24 -
Comment
F Shareholder value principals are
common-sense tools
to make a business more competitive
(This is closing line of Rappaport article)
l
l
F Goal of strategy is clear
to make investment decisions that lead to greater shareholder
value
(This is opening line of Amram & Kulatilaka article)
l
- 25 -
Components of discipline
F Decision is structured, or framed, in terms of
the options it creates
F All the relevant information on value and risk
available in the financial markets is taken into
account
F Financial market transactions are used to
acquire options or otherwise mitigate risk
l Sometimes cheaper to buy a financial option
than a real option
- 26 -
Fossil Inc.
Seiko
price
Opportunity
Space
Casio
Timex
quality
- 27 -
Complexity of the decision
Real Options Frontier
Place to look
for positive
NPV
Distance from financial markets
- 28 -
Flaw in Traditional Approaches
Cone of uncertainty
Terminal value
third investment
value
second investment
Initial investment
time
- 29 -
Limits of Discipline
F Model risk
F Imperfect proxies
F Lack of observable prices
F Lack of liquidity
F Private risk
- 30 -
Impediments to adopting RO
approach
F Perception of difficulty
F Myth that RO tends to find value where none
exists
F Shortage of value growth opportunities in
several large industries
F Short value growth duration in emerging
industries
- 31 -
Often options are limited
by the environment
F Economic limitations
F Technological limitations
F Political limitations
- 32 -
Porter’s Generic
Product/Market Strategies
Broad Market
Focused Market
Lower Cost
Differentiation
Cost Leadership
Differentiation
Cost Focus
Differentiation Focus
- 33 -
Porter’s method for analyzing
competitive environment
New Entrants
Suppliers
Industry Rivals
Customers
Substitutes
- 34 -
The physical value chain from a global
perspective:How much of it have we
covered so far?
Support Activities:
•Technology Development
•Human Resources
Development
Service
Distribution&
Marketing
Fabrication
Refining
Basic Extraction
Physical
Realm
Value Added at
Each Step
- 35 -
Virtual Value Chain &
Information Operations
GATHER AND APPLY IN THE PHYSICAL REALM
STORE AND TRANSFORM IN THE INFORMATION REALM
APPLY
PRESENT
DISTRIBUTE
SYNTHESIZE
Infosphere
SELECT
ORGANIZE
GATHER
- 36 -
Recognizing the Value of
Management Flexibility
Real Options Frontier
- 37 -
Why the sudden interest in
real options?
F We have had real option applications since
1978 (maybe even 1973)
l Calculate value of real options using pricing
methods developed for financial options
F “Real Options Approach” is more recent:
l This is a way of thinking that helps
managers formulate their strategic options
Source: Amram & Kulatilaka (2000)
- 38 -
Why the sudden interest in
real options?
Answer in two words: Demand and Supply
F The environment of uncertainty creates demand
l
l
l
l
Analysts cannot see very far into future
Sequential decisions: 1st round investment with clear expectation of
later expansion, modification, or abandonment
Management must consistently communicate progress (or
disappointments) to public markets, even before projects generate
cash flows
Need to evaluate profitless companies (like Internet startups)
F Supply has expanded
l
l
l
Advances in academic research
Growth of specialized consulting services
Improved information technology
- 39 -
Stewart Myers’
challenge (1984)
F Strategic planning needs finance
l Present value calculations are needed as a
check on strategic analysis and vice versa
l Standard discounted cash flow techniques
tend to understate the option value of
growing profitable lines of business
l Corporate finance theory requires extension
to deal with real options
- 40 -
Luehrman
Strategy as a Portfolio
of Real Options
F A business strategy is more like a series of
options than it is like a series of static cash
flows
F Options as Tomatoes
l
l
l
Some are ripe and perfect: pick immediately
Some are rotten: don’t bother to pick
In between:
—Edible but would benefit from more time: Pick now or
risk loss to birds?
—Not yet edible: No decision needed
- 41 -
- 42 -
DCF only
Augmented
- 43 -
- 44 -
Illustration using BlackScholes
Value of 1st year’s option = $1135.40
Value of 2nd year’s option = $1287.59
NPV = –2000 + 1135.40 + 1287.59 = $422.99
- 45 -
Lessons
F Rule 1: The more volatile the relation between
the prices of the input and output commodities,
the greater the difference between the true
NPV and the DCF-NPV
l Question: What real world factors influence
this correlation?
F Rule 2: The difference between the true NPV
and the DCF-NPV is greater the more
innovative the project, and the stronger the
barriers to entry
- 46 -
Rule 3: A company that has the same uses for
a system as another company, plus additional
operating options, will gain a higher NPV by
purchasing the system. That is, the more
flexible the system being considered, the
greater the difference between true NPV and
DCF NPV
- 47 -
Luehrman
Tour of Option Space
lower
higher
Direction of
increasing value
volatility
0.0
lower
value-to-cost
1.0
higher
- 48 -
Luehrman
Tour of Option Space
volatility
0.0
lower
lower
value-to-cost
1.0
higher
6:
Rotten tomatoes
Never invest
Region 1:
Region
ripe tomatoes
Invest now
Region 5:
Poor prospects
Maybe never
4:
Green tomatoes
higher Maybe later
Region
3:
Not yet edible
Probably later
Region 2:
Edible but early
Maybe now
Region
- 49 -
Buying Flexibility
(Trigeorgis & Mason)
F Expanded NPV = Static NPV + Option Premia
F Sources of Flexibility:
l Option to defer
—Licensing agreement
—Oil lease
l
l
l
Option to expand
Option to contract
Option to switch states
—Shut down temporarily
—Relocate production
Option to abandon
F Project Interdependence
l
- 50 -
Evaluating Flexibility
(Amran & Kulatilaka, 2000)
F Publicly-traded contingent claims
F Surrogate portfolios
F “Hybrid” Frameworks
l Tailored mix
l Discounted Cash Flow Analysis (DCF)
l Decision Tree Analysis (DTA)
l Simulation
l Dynamic Programming
l Contingent Claims Analysis (CCA)
F Summary:
l Market tracking
l Risk framing (may involve much art mixed with the science)
- 51 -
Clarification
(Amran & Kulatilaka, 2000)
F Strategic Options: Future opportunities
created by today’s investments
F Real options that can be tracked in the market:
l
Subset of strategic options in which the exercise
decision is largely triggered by market-priced risk
F Something that is private risk today may be
securitized in the future
l
l
l
Bandwidth trading
Weather derivatives
Profitless IPOs
- 52 -
Market Tracking
(Amran & Kulatilaka, 2000)
Continuum of applicability:
F Copper mine
l
Liquid & well-function markets in spot, futures, and other
derivatives
F Gas-fueled Electric Power Generation Plant
l
l
Futures, options, and derivatives available for input and
output
May be large difference between local pricing and market
benchmarks
F Semiconductor Memory Fab
l
Data provided by spot & forward trading of chips may be
sporadic
- 53 -
Example of Complex Options
Phases of Oil Exploration
(Amran & Kulatilaka, 2000)
Early
Exploration
Late
Exploration
Development
Exploitation
Option on
Option on
Option on
Underlying
Asset
‹—Option on
‹—Option on
‹—Underlying
Option on
Underlying
Asset
Underlying
Asset
Asset
Presence of oil Quantity of oil
unknown
unknown
Cost of
development
unknown
- 54 -
Pharmaceutical Development:
Not Market-Trackable RO
(Amran & Kulatilaka, 2000)
Phase I
Years: 1
Cost: $15 mm
Prob: 75%
Is compound
safe?
What is target
condition?
Phase II
Years: 1.5
Cost: $30 mm
Prob: 50%
Phase III
Years: 3
Cost: $200mm
Prob: 65%
Is compound
effective for
target condition?
Is it safe?
Right dose?
Safe and
effective for
large groups
with target
condition?
New Drug
Application
Years: 1
Cost: $7 mm
Prob: 65%
Do regulators
agree it’s safe?
What goes on
label?
- 55 -
Basics of Simple Financial Options
Purpose:
Provide background on the basics of
Option Pricing Theory (OPT)
- 56 -
Put-Call Parity
Consider two
portfolios
• Portfolio A
contains a call and
a bond:
VA
C(S,X,t) + B(X,t)
• Portfolio B contains
stock plus put:
VB
S*<X
0
+X
=X
X-S
+S
=X
S*>X
S-X
+X
=S
0
+S
=S
S + P(S,X,t)
- 57 -
Put-Call Parity
F If S* < X, Payoff for either portfolio is X
dollars
F If S* > X, Payoff for either portfolio is S*
F Therefore
C(S,X,t) + B(X,t) = S + P(S,X,t)
- 58 -
Keys for using OPT as an
analytical tool
C(S,X,t) = S - B(X,t) + P(S,X,t)
C
Call
S
B(X,t)
Stock
- 72 -
C
X
C
R
C
l
S
Call
Keys for using OPT as an
analytical tool
C(S,X,t) = S - B(X,t) + P(S,X,t)
B(X,t)
Stock
- 74 -
S
C
P
X
C
P
R
C
P
t
C
P
s
C
P
Call
Keys for using OPT as an
analytical tool
C(S,X,t) + B(X,t) = S + P(S,X,t)
B(X,t)
Stock
- 77 -
Basic Option Strategies
F Long Call
F Long Put
F Short Call
F Short Put
F Long Straddle
F Short Straddle
- 78 -
Long Call
$
0
-C
X
S
X+C
- 79 -
Long Call
Short Call
$
C
$
0
-C
X
S
X+C
0
X+C
X
S
- 80 -
$
0
-C
S
X
$
X+C
Short Call
Long Call
Long Put
$
C
0
X+C
S
X
X-P
0
X
-P
S
- 81 -
$
0
-C
Long Put
$
0
-P
S
X
X+C
$
C
0
X+C
S
X
$
P
X-P
X
Short Call
Long Call
Short Put
S
0
X
S
X-P
- 82 -
0
-C
S
X
X+C
Long Put
$
X-P
0
X
-P
$
S
$
C
Short Call
$
0
X+C
S
X
$
P
Short Put
Long Call
Long Straddle
0
X
S
X-P
X-P-C
0
S
X
-(P+C)
X+P+C
- 83 -
0
-C
S
X
X+C
X-P
0
X
-P
Long
Straddle
Long Put
$
$
0
-(P+C)
S
$
C
0
X+C
S
X
$
P
0
X
S
X+P+C
S
X-P
$
P+C
X-P-C
X
Short Call
$
Short Put
Long Call
Short Straddle
X+P+C
0
X
X-P-C
S
- 84 -
Impact of Limited Liability
C(V,D,t) = V - B(D,t) + P(V,D,t)
Equity
F Equity = C(V,D,t)
F Debt = V - C(V,D,t)
B(D,t)
V
- 85 -
Lessons we can learn even
with simple models
F
F
The discounted cash flow NPV, using expected prices of
the input and output commodities at future dates,
represents only the lower bound of the project’s true
NPV.
The true NPV may be significantly higher than the
DCF estimate.
- 86 -
Lessons
F
The more volatile the relationship between the
prices of input and output commodities, the
greater the difference between the true project
NPV and the discounted cash flow NPV.
- 87 -
Lessons
F
The difference between the true project NPV
and the discounted cash flow NPV is greater:
l the more innovative the project, and
l the stronger the barriers to entry for
potential competitors.
- 88 -
Lessons
F A company with the same potential uses for a system as
another company, plus one or more additional uses,
will gain a higher NPV by purchasing the system.
l Thus, the NPV of a project may differ from one
company to another,
l And companies with more flexibility have an
advantage in generating positive net present value.
- 89 -