What is the generalized formula to calculate the value of a call option?
- Value = Stock price - PV of strike price
- Because we're taking the PV, the higher the discount rate the lower the PV
When do the following options have value (1) call, (2) put
- Call: When the spot price is more than the strike price
- Put: When the spot price is less than the strike price
When you purchase an option, the option should be treated as an [asset / liability].
As an asset, with a value of greater than or equal to $0. At no time is it a liability.
What factors increase the value for a call option using the Black-Schols method?
- The greater the difference (spread) between the stock price and the exercise price.
- The greater the volatility of the stock, the more you are apt to receive for the call option, and the less you are apt to pay.
- The higher the risk-free rate
- The more time you have to exercise the option
Explain the Black-Schols method in high-level terms. What factors increase the value of the option?
- What we get when exercising the option = stock price x a probability that we're actually going to exercise the option.
- How much it costs us to exercise = strike price x a probability that we're actually going to exercise the option.
- The [....] the greater the probability we'll exercise the option (which increases the option's value)
- (1) higher the risk free rate
- (2) greater the % spread between the spot price & the strike price
- (3) greater the volatility (level of risk) of the stock (price fluctuation)
- (4) longer the time we have to exercise the option
What assumptions underlie the Black-Scholes model
- Stock prices behave randomly
- The risk-free rate is constant over the option's life
- The stock price volatility is constant over the option's life
- The stock pays no dividends
- The options are European-style (one single exercise date; American-style offers an exercise period [range])
What are the limitations of the Black-Scholes model
- The results may differ considerably from real prices
- Assumes instant and cost-less trading (which doesn't actually happen)
- It underestimates extreme price movements
- It cannot be used with American-style options because of the exercise time range (instead of a precise date).
What assumptions underlie the Binomial model
- There exists a perfectly efficient stock market
- The security price will move up or down at certain points in time (discrete) during the life of the option (called a node)
- We must be able to predict the percentage increase and decrease at those nodes.
What are the benefits of the Binomial model
- It can be used over a period of time, and thus can be used for the American-style options
- It can be used for stocks that pay dividends
WHITE BOARD: A $1,000 face value bond maturing in 3 years pays annual interest of 4%. What is the bond's price if the market rate at the time of issuance is 5%.
- Year 1: $38.10
- Year 2: $36.28
- Year 3: $898.39 (don't forget to include the bond's principal in this calculation)
True/False: When valuing a bond, you may use a different discount rate for each year until the bond's maturity.
What are the methods used to value tangible assets?
- "Stay CALM"
- Cost: Original cost. It may be reduced by accumulated depreciation to reflect current utility (aka book value)
- Appraisal Value: by a professional appraiser, but still subjective and less reliable.
- Liquidation Value: what price would be obtained if the asset absolutely had to be sold now. Usually the lowest value.
- Market Value: one of these two methods
- ** Replacement Cost = what it would cost to replace the asset in today's market
- ** Net Realizable Value = what it could be sold for in the marketplace - selling costs
- ** Or use the average of the two
What are the methods to value intangible assets?
- "Just ask MIC"
- Market Value: preferred but difficult as there isn't often an active market. If a market exists, can use a range, a median price, or select an item most closely related (a comp)
- Income Approach: The PV over the expected future cash flows during the useful life of the asset
- Cost Approach: one of the following
- ** replacement = what it would cost to create a similar asset
- ** reproduction = what it would cost to reproduce the same asset
- ** These costs include direct labor & materials, overhead, legal and other fees, development, production, and opportunity.
When performing valuation of fixed assets, which of the following is the least acceptable method? (1) expected usage, (2) historical info, (3) marketing info, (4) industry consensus
(4) industry consensus due to the unique nature of most company's fixed assets