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Valuation of options, Understanding How Options Are Priced

There are Cablevision bonds, due inthat have been traded from toand the variance in ln monthly price s for these bonds is 0. The correlation between stock price and bond price changes has been 0. In most such investments, there is a cost associated with developing the resource, and the difference between the value of the asset extracted and the cost of the development is the profit to the owner of the resource.

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Time to Expiration Relinqushment Period: if asset has to be relinquished at a point in time. Time to exhaust inventory - based upon inventory and capacity output.

Valuation of options

Variance in value of underlying asset based upon variability of the price of the resources and variability of available reserves. Development Lag Calculate present value of reserve based upon the lag. Illustration 9 : Application to valuation: A gold mine Consider a gold mine with an estimated inventory of 1 million ounces, and a capacity output rate of 50, ounces per year.

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The firm owns the rights to this mine for the next twenty years. Every year of delay implies a loss of one year of production.

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The additional value accrues directly from the mine's option valuation of options. The estimated opportunity cost of this delay is the lost production revenue over the delay period.

Remember that options are totally separate entities to the underlying assets from which they are derived hence, the term derivative. But in themselves they do have a value, which can be split into two parts: intrinsic value and time value. Out-of-the-money OTM options will have no intrinsic value, and their price will solely be based on time value. Time value is another way of saying hope value.

Extending the option pricing approach to value natural resource firms Since valuation of options assets owned by a natural resource firm can be viewed primarily as options, the firm itself can be valued using option pricing theory.

The preferred approach would be to consider each option separately, value it and cumulate the values of the options to get the valuation of options of the firm. Since this information is likely to be difficult to obtain for large natural resource firms, such as oil companies, which own hundreds of such assets, a variant of this approach is to value the entire firm as one option.

A purist would probably disagree, arguing that valuing an option on a portfolio of futures options as in this approach will provide a lower value than valuing a portfolio of options which is what the natural resource firm really own.

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Nevertheless, the value obtained from the model still provides an interesting perspective on the determinants of the value of natural resource firms. Inputs to the Black-Scholes Model Input to model Corresponding input for valuing natural resource firm Value of underlying asset Value of cumulated estimated reserves of the resource owned by the firm, discounted back at the dividend yield for the development lag.

Exercise Price Estimated cumulated cost of developing estimated reserves Time to expiration on option Average relinquishment period across all reserves owned by firm if known or estimate of when reserves will be exhausted, given current production rates.

The Valuation of Options | Introduction to Options | InformIT

Riskless rate Riskless rate corresponding to life of the option Variance in value of asset Variance in the price of the natural resource Dividend yield Estimated annual net production revenue as percentage of value of the reserve. The average relinquishment life of the reserves is 12 years. The bond rate at the time of the analysis was 9.

Intrinsic value[ edit ] The intrinsic value is the difference between the underlying spot price and the strike price, to the extent that this is in favor of the option holder. For a call optionthe option is in-the-money if the underlying spot price is higher than the strike price; then the intrinsic value is the underlying price minus the strike price. For a put optionthe option is in-the-money if the strike price is higher than the underlying spot price; then the intrinsic value is the strike price minus the underlying spot price. Otherwise the intrinsic value is zero. This is called the time value.

The variance in oil prices is 0. The present value of these developed reserves, discounted at the weighted average cost of capital of Valuing product patents as options The General Framework A product patent provides the firm with the right to develop the product and market it. It will do so only if the present value of the expected cash flows from the product sales exceed the cost of development.

If this does not occur, the firm can shelve the patent and not incur any further costs.

Getting to the Greeks: The Comprehensive Guide to Option Pricing

Variance in value of underlying asset Variance in cash flows of similar assets or firms Variance in present value from capital budgeting simulation. Exercise Price on Option Option is exercised when investment is made.

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Cost of making investment on the project; assumed to be constant in present value dollars. Expiration of the Option Life of the patent.

During his two-decade career in Asia and the US, Nathan has consulted in strategy, valuations, corporate finance and financial planning.