AFM476: Real Options

y y y DCF ignores options that are embedded into many corporate projects Real option approach is the extension of option pricing theory to options in real assets Helps managers to plan and manage strategic investments

Types of Real Options

1. Timing option (when to take certain actions) 2. Option to expand 3. Option to abandon

Problems with Valuation of Real Options

y y y y Underlying asset not traded and hard to value Pricing of the asset may not follow a continuous process Variance may not be known or may change over the life of the option Exercising may not be instantaneous

Options Valuation Calls

Options Valuation Puts

Timing of Projects
1. When a firm has exclusive rights to a project or product for a specific period, it can delay taking this project or product until a later date. 2. Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. The value of these rights increases with the volatility of the underlying business. 3. The cost of acquiring these rights (by buying them or spending money on development, for instance) has to be weighed off against these benefits.

Option to Expand
1. Taking a project today may allow a firm to consider and take other valuable projects in the future. 2. A firm may accept a negative NPV on the initial project because of the possibility of high positive NPVs on future projects

Example for Expansion

Assume that Home Depot is considering opening a small store in France. The store will cost 100 million FF to build, and the present value of the expected cash flows from the store is 80 million FF. Stand-alone investment NPV = -$20m By opening this store, Home Depot acquires the option to expand into a much larger store any time over the next five years. The cost of expansion will be 200 million FF, and it will be undertaken only if the present value of expected cash flows exceeds 200 million FF. At the moment, the present value of the expected cash flow is believed to be only 150 million FF. The standard deviation in the underlying assets value is 28.3%. The risk-free rate is 6.00%. Should Home Depot open the store in France?

AFM476: Risk Management

Regression Method
y y Estimate risk based on factor betas derived from historical returns Fama French, is an example of an APT regression method to quantify risk

Simulations
y y Forecast returns or cash flows for a variety of factor realizations Ex. a wide range of exchange rates, profit estimates or FCFs

VAR
Given a distribution of daily returns, VAR is the highest value within the bottom 5% of returns. For example, if the high end of the 5% left tail is -10% and we have a portfolio of $1M, then the value-atrisk is $100,000. Can be calculated for whatever interval. On a portfolio, the VAR assumes that no additional trading was done during the day. y y y y y y y y A single number used to encapsulate a firm s market risk Used commonly to measure the risk to value of a portfolio of securities Easy to find, and intuitive for non-finance people to understand. The preferred method under Basel accords for banking regulation % change of at least a specific loss Says nothing about the size of the loss within the % limit o Just an amount above a specific size Historical simulation uses past data to generate rolls of the dice Delta-method: uses distributions and covariances to derive a distribution for the portfolio Monte Carlo method: uses simulation about historical distributions

VARs for different positions

y WFC y WFC+AAPL y WFC+AAPL+XOM y WFC+AAPL-XOM Which one of the above has higher VAR? WFC by itself probably has the highest VAR. Diversification reduces value-at-risk.