CORPORATE FINANCE FOR

LONG-TERM VALUE

Chapter 19: Options

 Part 5: Corporate financial policies

Chapter 19: Options

 The BIG Picture
3

 Options are contracts that give the owner the right to buy or sell a security at a pre-specified price

Discussion

 Financial options can be used to deal with uncertainty (e.g. declining price)

 A real option is the opportunity to make a particular business decision, exemplifying the value of
flexibility

 Real options on F can have E or S drivers: payoff in terms of F, but with E or S as the underlying
values

 Companies have a lot of put options against society, but awareness of them is low: this calls for
integrated value expressed in real options
 Financial options
4

 Financial options are option contracts that give their owners the right to sell or buy a
security from the writer of the contract at a specified price
exercise / strike price
 The two parties to the contract have opposite positions:
 The buyer (owner) is long the option and has a right (not obligation) to buy or sell

 The seller (writer) is short the option and has the obligation to fulfil the contract

 The owner pays a price for the option to the seller, known as the option premium

 Two types of options:

 Call options, which gives the owner the right to buy a security Security can be:
company stock, exchange
 Put options, which gives the owner the right to sell a security rate, interest rate, commodity,
etc.
 Call option – long
5

 Consider the example of a call option on a bushel of wheat, with an exercise price of $10

 The underlying value is the price of the bushel of wheat

 The payoff is $0 for every price < $10 12

10
 For every price > $10, the payoff is:
8

Pay-off
price – exercise price 6
Payoff at > $10

4
 The formula for a long position in a call is:
2 Payoff at < $10
𝐶 = max(𝑆 − 𝐾, 0) 0
0 1 2 3 4 5 6 7 8 9 1011121314151617181920
Where 𝑆 is the underlying value and 𝐾 the exercise price Underlying value: price of a bushel of wheat
 Call option – long (with premium)
6

 The longer the maturity of the call, the higher the probability that the underlying value will
at some time exceed the strike price and the higher its value

 Since it has value, investors will be willing 12

10
to pay a price for it, called a premium
8
Payoff at > $10
 Suppose the premium for a bushel of wheat 6

Profit
is $0.40, then the payoff structure becomes → 4
Break-even
2 Payoff at < $10 point: $10.40

 Note that premiums are not fixed: they move 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

with the price of the underlying security -2

Underlying value: wheat price

 The buyer pays the premium to the seller at the time both parties enter into the contract,
at which time the premium payment is fixed
 Call option – short
7

 The seller, who writes the call, has the exact opposite payoff profile to the buyer
 The payoff is $0 for every price < $10 Payoff at < $10
2
0
 For every price > $10, the payoff is: 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-2

- (price – exercise price)

Pay-off
-4
-6

 The formula for a short position in a call is: -8

Payoff at > $10
-10
-12
−𝐶 = −max(𝑆 − 𝐾, 0) Underlying value: wheat price

2
Including $0.40 premium
Where 𝑆 is the underlying value and 𝐾 the exercise price 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-2

-4

Profit
-6

-8

-10

-12
Underlying value: wheat price
 Put option – long
8

 A put option gives the owner the right to sell a security

 For every price < $10, the payoff is: 12

exercise price – price 10

8
 The payoff is $0 for every price > $10

Pay-off
Payoff at < $10
6

 The formula for a short position in a call is: 4

Payoff at > $10
2
𝑃 = max(𝐾 − 𝑆, 0)
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Where 𝑆 is the underlying value and 𝐾 the exercise price Underlying value: wheat price
 Put option – short
9

 The seller, who writes the put, has the exact opposite payoff profile versus that of the
buyer
Payoff at > $10
2

 For every price < $10, the payoff is: 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
- (exercise price – price) -2

-4

Pay-off
 The payoff is $0 for every price > $10
-6
Payoff at < $10
 The formula for a short position in a call is: -8

-10
−𝑃 = max(𝐾 − 𝑆, 0)
-12
Underlying value: wheat price
Where 𝑆 is the underlying value and 𝐾 the exercise price
 Combinations of options & hedging
10

 In practice people can have composite exposures: they may use options to hedge their exposures

 Example: a farmer has a profit which depends on the wheat price

 Costs are $5 per bushel, so profit is: wheat price - $5 (left graph)

 By buying the put option with exercise price $10, the farmer gets protection against losses (middle graph)

 The farmer’s payoff: profit before hedging (S - $5) plus the put’s payoff (max[K-S,0]) minus the put’s premium:
(S - $5) + max(K-S,0) - $0.40 → at all prices below $10, profit is locked in at $4.60  farmer buys protection at a cost of $0.40

Farmer profit before hedging Put option (including premium) Farmer profit after hedging
20 20 20
15 15 15
10 10 10
Pay-off

Pay-off
Pay-off

5 5 5
0 0 0
-5 0 2 4 6 8 10 12 14 16 18 20 -5 0 2 4 6 8 10 12 14 16 18 20 -5 0 2 4 6 8 10 12 14 16 18 20
-10 -10 -10
Underlying value: wheat price Underlying value: wheat price Underlying value: wheat price
 Combinations of options & hedging
11

 A producer of packaged food faces an (almost) opposite exposure

 The price per bushel hurts its profits since the food company needs to buy wheat for its production
 Profit per bushel: $17 – price per bushel (left graph)

 By buying a call option with exercise price $10, the food company gets protection against losses (middle graph)

 The food company’s payoff: profit before hedging ($17 - S) plus the call’s payoff (max[S-10,0]) minus the put’s premium:
($17 - S) + max(S-10,0) - $0.40 → at all prices above $10, profit is locked in at $6.60  company buys protection at a cost of $0.40

Food co profit before hedging Call option (including premium) Food co profit after hedging
20 20 20
15 15 15
10 10
Pay-off

Pay-off

Pay-off
10
5 5
5
0 0
0 -5 0 2 4 6 8 10 12 14 16 18 20 -5 0 2 4 6 8 10 12 14 16 18 20
0 2 4 6 8 10 12 14 16 18 20
-5 -10 -10
Underlying value: wheat price Underlying value: wheat price Underlying value: wheat price
 Put-call parity
12

 The exposure of the farmer looks like the call option of the
20

producer, but at a higher level (including a bond) 15

10

Pay-off
5
 The exposure of the producer looks like the put option of 0
-5 0 2 4 6 8 10 12 14 16 18 20
the farmer, but at a higher level (including underlying)
-10
Underlying value: wheat price
 From this, the assumption follows:
20
𝑆+𝑃 =𝐵+𝐶 15
10

Pay-off
➢ The combined payoffs of the underlying value 𝑆 and the 5
0
put 𝑃 are equal to the combined payoffs of a bond 𝐵 and a -5 0 2 4 6 8 10 12 14 16 18 20
-10
Underlying value: wheat price
call 𝐶 next slide shows put-call parity
 Put-call parity expressed in payoff structures
13

S (stock) P (put)
20 20

10 10

Pay-off
Pay-off

0 0
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20 S+P=B+C
20
-10 -10

10
-20 -20
Underlying value Underlying value

Pay-off
0
0 2 4 6 8 10 12 14 16 18 20
20 B (bond) 20 C (call) -10

10 10
-20
Underlying value
Pay-off

Pay-off

0 0
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20

-10 -10

-20 -20
Underlying value Underlying value
 Capital structure expressed in options
14

 One can view capital structure in terms of options:

 Equity can be seen as a call option on the company’s assets NPV of projects 20 Debt 5

 Corporate debt is effectively riskless debt minus a put on the Equity 15

company’s assets Total assets 20 Total liabilities 20

 The NPV of projects is the driver of the value of

assets and the value of equity Call value of equity
35
 If the NPV of projects falls below 5, equity value goes to 0 30 Value of equity at the current value
of the company (20) and a strike

Pay-off to equity
25
 For all values above 5, the value of equity price (value of debt) of 5
20
moves proportionately with the NPV of projects 15
10
5

𝐸𝑞𝑢𝑖𝑡𝑦 𝑎𝑠 𝑎 𝑐𝑎𝑙𝑙 = 𝐶 = max(𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐷𝑒𝑏𝑡, 0) 0

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
Underlying value: company value
 Corporate debt in terms of options
15

 Since equity can be expressed in options, it follows from put-call parity that
corporate debt can also be expressed in terms of options
𝑆+𝑃 =𝐵+𝐶
Where 𝑆 = assets, 𝑃 = put on assets, 𝐵 = riskless debt and 𝐶 = call on assets

 As such: assets = 𝑆 = 𝐵 − 𝑃 + 𝐶

 Assets are financed by risky debt and equity, and since equity = 𝐶, it follows:
𝑅𝑖𝑠𝑘𝑦 𝑑𝑒𝑏𝑡 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵 − 𝑃 + 𝐶 − 𝐶 = 𝐵 − 𝑃

Risky debt = riskless debt – put on assets

 Corporate debt in terms of options
16

Value of risky debt is 5 at the

Below a company value current value of the
of 5, the written put has a company (20) and a strike
negative payoff price of the put of 5
 Option quotations
17

 Options are most commonly traded on stocks

 Example of 3M stock with 3 strike prices
 Strike price is the fixed price at which the owner of
Strike* C or P Bid* Ask* Open interest the option can by or sell the underlying security

 Bid price is the price at which the market-makers

C 53.50 55.55 0
60 are willing to buy the option
P 2.97 3.90 20
C 20.50 21.75 17  Ask price is the price at which the market-makers
110 are willing to sell the option
P 16.90 18.00 64
C 5.65 6.45 25  Open interest refers to the number of option
160 contracts that are held by traders in active positions
P 49.15 50.70 2

* Per October 2022, with expiration in January 2025

 Option quotations
18

 As of October 2022, 3M stock was $113.45  At $60, the call option is very much ‘in-the-money’, whereas the
put option is ‘out-of-the-money’

Strike* C or P Bid* Ask* Open interest  The difference between the stock price and exercise price is the
intrinsic value of the option
C 53.50 55.55 0
60
P 2.97 3.90 20  For $60 call option: $113.45 - $60 = $53.45
C 20.50 21.75 17  For $60 put option: $60 - $113.45 = 0
110
P 16.90 18.00 64
 The average of the bid and ask is the option value
C 5.65 6.45 25
160
P 49.15 50.70 2  The option value minus the intrinsic value is called the time

* Per October 2022, with expiration in January 2025 value of the option

 For $60 call: ($55.55 + $53.50) / 2 = $54.53 - $53.45 = $1.08

𝑶𝒑𝒕𝒊𝒐𝒏 𝒗𝒂𝒍𝒖𝒆 = 𝒊𝒏𝒕𝒓𝒊𝒏𝒔𝒊𝒄 𝒗𝒂𝒍𝒖𝒆 + 𝒕𝒊𝒎𝒆 𝒗𝒂𝒍𝒖𝒆
 For $60 put option: ($3.90 - $2.97) / 2 = $3.44 - $0 = $3.44
(see next slide)
 Option value = intrinsic value + time value
19

Value 5

4
option value
3 (red line)

2 intrinsic value
(blue line)
1
time value strike price, K
0
0 1 2 3 4 5 6 7 8 9 10
Stock price
 Valuing options
20

 The non-linear nature of option payoffs makes valuation of options difficult

 The binomial option pricing model prices options by making the simplistic assumption that
at the end of the next period (𝑟𝑓 = 3%), the underlying value has only two possible values

 The two-state single period model values a call option by building a replicating portfolio,
which is a portfolio of other securities with the same value as the option in one period

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑢 = max($12-$10,$0) = $2
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑑 = max($8-$10,$0) = $0
 Binomial model – step 1
21

 The idea is to buy stock in such proportions that they give the same payoffs as the call

 The first step is to determine the option delta Δ (or hedge ratio), which is the number of
stocks needed to replicate or hedge the call:

spread of possible option prices 𝐶 −𝐶 $𝟐−$𝟎

Δ = spread of possible stock prices = 𝑆𝑢 −𝑆 𝑑 = $𝟏𝟐−$𝟖 = 0.5
𝑢 𝑑

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑢 = max($12-$10,$0) = $2
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑑 = max($8-$10,$0) = $0
 Binomial model – step 2
22

 The second step is to determine the number of bonds needed to finance the stock position

 The replication, for one time period later, is:

∆∙𝑆𝑢 −𝐶𝑢
 For the up-state: 𝐶𝑢 = ∆ ∙ 𝑆𝑢 − 1 + 𝑟𝑓 ∙ 𝐵 To derive the number of bonds: 𝐵 =
1+𝑟𝑓
0.5 ∙ $𝟏𝟐 − $𝟐
 For the down-state: 𝐶𝑑 = ∆ ∙ 𝑆𝑑 − 1 + 𝑟𝑓 ∙ 𝐵 Up-state: 𝐵 = = $3.88
1.03
0.5 ∙ $𝟖 − $𝟎
Down-state: 𝐵 = = $3.88
1.03

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑢 = max($12-$10,$0) = $2
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑑 = max($8-$10,$0) = $0
 Binomial model – step 3
23

 The final step is to determine the price of the call

 The price of the call option in the binomial model is as follows:

Value of call = [delta x stock price] - [bonds]

𝐶 = ∆∙𝑆−𝐵
𝐶 = 0.5 ∙ $10 − $3.88 = $1.12

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑢 = max($12-$10,$0) = $2
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑑 = max($8-$10,$0) = $0
 Binomial model – step 4 (overview)
24

Period t = 0 Period t = 1
Instrument
Up Down

∆∙𝑆−𝐵 = ∆ ∙ 𝑆𝑢 − 1 + 𝑟𝑓 ∙ 𝐵 = ∆ ∙ 𝑆𝑑 − 1 + 𝑟𝑓 ∙ 𝐵 =
Replicating portfolio 0.5*$10 - $3.8835 = 0.5 * $12 – (1.03) * $3.8835 = 0.5 * $8 – (1.03) * $3.8835 =
$1.1165 $6 - $4 = $2 $4 - $4 = $0

Call 𝐶 = $1.12 𝐶 = $2 𝐶 = $0

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑢 = max($12-$10,$0) = $2
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝐶𝑑 = max($8-$10,$0) = $0
 Put option in binomial model
25

 The calculation of the put price occurs in a similar way to the call price

spread of possible option prices 𝑃 −𝑃 $0−$2

Option delta Δ = spread of possible stock prices = 𝑆𝑢 −𝑆 𝑑 = $12−$8 = −0.5
𝑢 𝑑

−∆∙𝑆𝑢 +𝑃𝑢 − −0.5 ∙$12+$0

Number of bonds 𝐵 = = = $5.83
1+𝑟𝑓 1.03

Value of put = [delta x stock price] + [bonds] = 𝑃 = ∆ ∙ 𝑆 + 𝐵 = −0.5 ∙ $10 + $5.83 = $0.83

Stock: Bond: Call:

up 𝑆𝑢 = $12 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝑃𝑢 = max($10-$12,$0) = $0
Stock: S = $10
Bond: B = $1
down Stock: Bond: Call:
𝑆𝑑 = $8 𝐵 ∙ 1 + 𝑟𝑓 = $1.03 𝑃𝑑 = max($10-$8,$0) = $2
 Multiperiod binomial model
26

 The formula for the option delta Δ can be interpreted as the sensitivity of the option’s value to changes in
the stock price at each point in time

 We can value the call option in the multiperiod binomial tree by working backwards from t = 2

t=0 t=1 t=2 Option deltas

up $14
𝐶𝑢 − 𝐶𝑑 $4 − $0
Δ= = =1
$12 𝑆𝑢 − 𝑆𝑑 $14 − $10
up
down
S = $10 $10
up
down 𝐶𝑢 − 𝐶𝑑 $0 − $0
$8 Δ= = =0
𝑆𝑢 − 𝑆𝑑 $10 − $6
down
$6 A call with zero payoffs in the future,
also has zero value today
 Multiperiod binomial model
27

∆∙𝑆𝑢 −𝐶𝑢 1∙$14−$4

𝐵= = = $9.709
1+𝑟𝑓 1.03

𝐶 = ∆ ∙ 𝑆 − 𝐵 = 1 ∙ $12 − $9.709 = $2.291 Value of call option in the up-state at t = 1

t=0 t=1 t=2

up $14

up $12
down
S = $10 $10
up
down
$8

down
$6
 Multiperiod binomial model
28

𝐶𝑢 −𝐶𝑑 $2.291−$0
Δ= = = 0.573
𝑆𝑢 −𝑆𝑑 $12−$8

∆∙𝑆𝑢 −𝐶𝑢 0.573∙$12−$2.291 Value of call option at t = 0,

𝐵= = = $4.449 Slightly higher than the one-period call
1+𝑟𝑓 1.03
with a value of $1.12
𝐶 = ∆ ∙ 𝑆 − 𝐵 = 0.573 ∙ $10 − $4.449 = $1.279

t=0 t=1
Stock: Call:
up 𝑆𝑢 = $12 𝐶𝑢 = $2.291

S = $10

down Stock: Call:

𝑆𝑑 = $8 𝐶𝑑 = $0
 Option pricing models
29

1. From binomial option pricing model for two periods

2. To multiperiod binomial option pricing model for multiple periods

 Refine the tree by cutting the maturity of call option in ever smaller periods

 Ending up in a continuous returns distribution

0.45
0.40
0.35

3. To Black-Scholes option pricing model 0.30

Probability
0.25
0.20
 Based on normal distribution of returns 0.15
0.10
0.05
0.00
 Black-Scholes option pricing model
30

 The Black-Scholes formula for the price of a call on a non-dividend paying stock follows the set-up
of the binominal model:
Value of call = [delta x stock price] – [bonds]
𝐶 = 𝑁 𝑑1 ∙ 𝑆 − 𝑁(𝑑2 ) ∙ 𝑃𝑉 𝐾
Where:
• 𝑆 is the current price of the underlying stock
• 𝑃𝑉(𝐾) is the present value of a risk-free zero-coupon bond that pays 𝐾
• 𝐾 is the exercise price
0.45
• 𝑁(𝑑) is the cumulative normal probability distribution 0.40

ln[𝑆Τ𝑃𝑉 𝐾 ] 𝜎√𝑇 0.35

• 𝑑1 = + 0.30
𝜎√𝑇 2

Probability
0.25
• 𝑑2 = 𝑑1 − 𝜎√𝑇 0.20

• 𝜎 is annual volatility of the stock’s returns 0.15

0.10 N(d)
• 𝑇 refers to the number of years until expiration 0.05
0.00
0 d
 European dividend paying stocks
31

❑ The Black-Scholes formulas are derived for non-dividend paying stocks

❑ They can easily be adjusted for dividend paying stocks

❑ The European call option holder has no rights to any dividends paid out prior to expiration
❑ European options can only be exercised at the expiration date

❑ American options allow the owner to exercise the option at any time

❑ For European call options, we can deduct the present value of missed dividends
𝑃𝑉(𝐷𝑖𝑣) from the stock price 𝑆:
𝑆∗ = 𝑆 − 𝑃𝑉(𝐷𝑖𝑣)
 Implied volatility & risk of options
32

❑ While most parameters are easy to calculate, volatility of stock price σ is more difficult to calculate
❑ The most direct way is to calculate a stock’s volatility from historical stock prices

❑ Traders sometimes take a shortcut by deriving a stock’s volatility from current market prices of traded options

❑ Estimating a stock’s volatility that is implied by an option’s market price is called implied volatility

❑ We can derive the risk of an option from the underlying replicating portfolio
❑ The beta of the option 𝛽𝑜𝑝𝑡𝑖𝑜𝑛 is a weighted average of the beta of the stock and the bond
∆∙𝑆 𝐵
𝛽𝑜𝑝𝑡𝑖𝑜𝑛 = ∙ 𝛽𝑠𝑡𝑜𝑐𝑘 + ∙𝛽
∆∙𝑆+𝐵 ∆ ∙ 𝑆 + 𝐵 𝑏𝑜𝑛𝑑
∆∙𝑆
❑ Given that the bond is risk-less, 𝛽𝑏𝑜𝑛𝑑 = 0 𝛽𝑜𝑝𝑡𝑖𝑜𝑛 = ∆∙𝑆+𝐵 ∙ 𝛽𝑠𝑡𝑜𝑐𝑘

❑ While the beta of a call is positive, the beta of a put is typically negative reflecting the short position in stocks
 Drivers of option prices
33

❑ The Black-Scholes formulas reveal the drivers of option prices

❑ Drivers have different signs for calls and puts (see table)

Strike
price
Driver Call option Put option Risk-free
Underlying
interest
value
Underlying value + - rate
Volatility + +
Strike price - + Time to Option Volatility
Time to expiration + + expire price
Risk-free interest rate + -
 Real options
34

❑ A real option is the opportunity to make a particular business decision gives flexibility

❑ In contrast to financial options:

❑ They are not exchange traded

❑ There is no formal option contract

❑ There is no clear counterparty

❑ Similar to financial options, real options have a payoff that depends on factors such as the underlying value and a
strike price on that underlying value
❑ Being long in real options provides valuable flexibility to exercise an opportunity

❑ Being short in real options can be very risky and value destructive

❑ You typically cannot price real options by no-arbitrage principles since these real options are not redundant
❑ This means you cannot make a replicating portfolio to price real options
 Application of real options
35

❑ Many corporate assets, particularly growth opportunities, can be viewed as call options (Myers, 1977)

❑ Such ‘real options’ depends on discretionary future investment by the firm

❑ Example: a company has developed an innovative technology

❑ The company now has a put option on the production costs of the innovative technology

❑ The strike price is the production cost of the traditional technology

❑ When costs of the innovative technology go down, the put option comes ‘in-the-money’

❑ Luehrman (1998): “In financial terms, a business strategy is much more like a series of options
than a series of static cash flows”
 Types of real options
36

❑ Koller, Goedhart and Wessels (2020) provide a classification of real options:

❑ Option to defer (a call): flexibility to wait and do the same action later

❑ Abandonment option (put): option to stop an operation

❑ Follow-on (compound) option: a series of options on options

❑ Option to expand (call) or contract (put): flexibility in the size of the operations

❑ Option to extend (call) or shorten (put): flexibility to adapt the lifetime of an operation

❑ Option to increase scope (call): flexibility to add other operations

❑ Switching options: flexibility to choose between different operations

 Drivers of real options
37

❑ Drivers of real options follow from the drivers of financial options

❑ Key point: uncertainty - measured as volatility of cash flows - enhances the flexibility value

Cash flows
existing
Investment business Lost cash
costs flows

Underlying
Risk-free
cash flows
interest rate
alternative

Enhances Uncertainty
Time to
expire flexibility (volatility)
value about CF

Source: Adapted from Koller, Goodhart and Wessels (2020)

 Decision tree analysis for real options
38

❑ Real options can be analysed using decision trees, which are a graphical representation of
future decisions under uncertainty

Example: investing in a mine

t=0 t=1 t=2
 The investment at t = 0 effectively
Metal prices rise $5500
(50% chance) million buys the company an exposure to
metal prices

Invest in a mine  Once the mine has been built at t = 0,

-$2500
million the investment in the mine is not a
Metal prices fall $800
call anymore at t = 1
(50% chance) million
 The call lies before that at t = 0: the

Don’t invest in a mine choice to build the mine or not

$0
 Decision tree analysis for real options
39

t=0 t=1 t=2

Metal prices rise $5500
(50% chance) million

Invest in a mine
-$2500
million
Metal prices fall $800
(50% chance) million

Conclusion: the expected payoff is positive,

Don’t invest in a mine $0
so the company should invest in the mine

Total
Expected Previous Total
Scenario Payoff (1) Probability (2) expected
payoff (3) payoff (4) payoff (5)
payoff (6)
Calculation (1)*(2) (1)+(4) (5)*(2)
Metal prices rise 5,500 50% 2,750 -2,500 3,000 1,500
Metal prices fall 800 50% 400 -2,500 -1,700 -850
Total 100% 3,150 650
 Corporate use of real options
40

❑ In corporate practice, the use of real options is not as widespread as academics had imagined
❑ Managers tend to favour DCF analysis in capex decisions, or simpler but flawed alternatives, such as
the payback criterion

❑ Triantis and Borison (2001) identify three main corporate uses of real options:
❑ As a strategic way of thinking

❑ As an analytical valuation tool

❑ As an organisation-wide process for evaluating, monitoring, and managing capital investments

❑ Often, managers are not aware of the options they have, since these options are not
explicitly presented as such (‘opaque framing’) and are thus not identified in the first place
 Real call positions driven by E and S
41

❑ How to think about real call options driven by E and S?

❑ On the long side, calls result from grasping E and S opportunities
❑ On the short side are incumbent companies that are currently destroying value on E or S

❑ The intrinsic value of the long call increases with the size of the positive externality (opportunity)

❑ The value of the short call decreases with the size of the negative externality (incumbent technology)

❑ The intrinsic value of the real call option increases with the attractiveness of the new technology and
decreases with the attractiveness of the incumbent technology

❑ As the new technology becomes competitive, the value of the long call goes up and might come in-
the-money, while that of the short call falls
 E and S drivers of real call options on F
42

Long call Short call

Size of the positive externality of the

new technology relative to the old + -
Underlying value technology
CFs new technology + -
Strike price CFs incumbent technology - +
Volatility Transition tensions + -
Economic life of the incumbent
Time to expiration
technology + -
Risk-free interest PV of the incumbent technology
rate (strike price) + -
 Example of DSM’s product Bovaer
43

❑ DSM has developed the product Bovaer, which reduces methane emissions of cows
❑ The development cost of Bovaer is the option premium at €4 per unit product
❑ The strike price of the call is the production cost of Bovaer at €5 per unit product
Note: these numbers are fictional and intended for illustrative purposes

Profit
 DSM will start producing and selling Bovaer 6
4
(i.e. exercising the call option) as soon as the 2
0
methane tax exceeds the strike price 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-2
Methane tax
 DSM will break even at a methane tax of €9 -4
-6

 From a short call perspective: as the transition tensions and/or size of externality increases
(i.e. the methane tax rises), the risk of doing nothing increases
 This should push companies to consider strategies that avoid this risk by phasing out old technologies
 Real put positions driven by E and S
44

❑ Practical example of a short put: Boeing taking short-curs in safety

❑ Every year Boeing benefits from cost reductions (put premium)

❑ Until one year this led to an accident and massive costs

❑ The underlying value is the safety level of the aircraft: the probability that no accidents happen
which will result in large fines
Long put Short put
Safety level as measured by:
❑ Safe transport and arrival of Underlying value - Health of passengers - +
- Avoiding multi-billion dollar fines - +
passengers is the threshold and Passengers arrive safely due to
Strike price
safety investment
+ -
strike price: below that price, Volatility Swings in resulting safety levels + -
costs rise significantly Time to expiration Use time of the planes produced + -

Risk-free interest rate PV of the safety investment - +

 Comparing call and put examples
45

❑ There are at least three differences between the put and call examples
❑ The put examples are not a transition risk: it is not a bigger societal challenge, but purely the result of
decisions to economise on safety

❑ The short puts are not driven directly by competing products: there is no new technology that can
eradicate the negative externality

❑ There is no clear counterparty that has the exact mirror position

❑ There are also similarities:

❑ Both long calls and short puts have a competitive element:
❑ Companies that invest in long calls increase their competitive composition by frontloading new technology

❑ Companies that write short puts increase their competitive position by cutting costs
 Integrated value as a set of real options
46

❑ Companies can create options for specific stakeholders (i.e. shareholders, employees)
at the expense of other stakeholders

❑ The integrated value perspective helps to make such situations visible, by explicitly
comparing EV, FV and SV S assets 20 S debt 5
S equity 15
❑ We can express the market value balance sheet as E assets 15 E debt 25
E equity -10
a combination of risk-free assets and liabilities and
F assets 25 F debt 5
options on F, S, and E F equity 20
Total integrated Total integrated
60 60
assets liabilities
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑅𝑖𝑠𝑘𝑦 𝑑𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵 − 𝑃 + 𝐶
𝐼𝑉 = (𝐸 𝑏𝑜𝑛𝑑 + 𝐸 𝑐𝑎𝑙𝑙 – 𝐸 𝑝𝑢𝑡) + (𝐹 𝑏𝑜𝑛𝑑 + 𝐹 𝑐𝑎𝑙𝑙 – 𝐹 𝑝𝑢𝑡) + (𝑆 𝑏𝑜𝑛𝑑 + 𝑆 𝑐𝑎𝑙𝑙 – 𝑆 𝑝𝑢𝑡)

see next slide

 IV balance sheet
47

EV = E bond + call on E - put on E

+ : natural capital improvements realised biodiversity damage resulting from

example: still to be realised emission savings
- : natural capital destruction caused activities

+
FV = F bond + call on F - put on F

potential additional CF from current potential reductions in CF from

example: CF from business as usual
/ new projects / products current / new projects / products

+
SV = S bond + call on S - put on S
still to be experienced health
+ : health improvements realised still to be realised health
example: reductions from, for example,
- : health reductions caused improvements
savings on safety

=
IV = I bond + call on I - put on I
 Conclusions
48

 Financial options are contracts that give the owner the right to buy or sell a security at a pre-specified price

 The seller or writer, who is short the option, has the opposite position of the buyer, and has to exercise the
contract if the buyer wants to do so

 A real option is the opportunity to make a particular business decision, exemplifying the value of flexibility

 One can visualise both financial options and real options with decision trees and payoff graphs

 Real options on F can have E or S drivers: payoff in terms of F, but with E or S as the underlying values

 Companies have a lot of put options against society, but awareness of it is low: this calls for an integrated view
on options or integrated value expressed in real options