Black and Scholes and Beyond

1. Black and Scholes and Beyond Professor XXXXX Course Name / Number

2. Stock prices can move at every moment in time. • Movements of stock prices are random, and therefore unpredictable. • Volatility (standard deviation) of stock’s movements is known. Assumptions of the model Black-Scholes Call Options Reasoning behind Black and Scholes is similar to that of the binomial model: Does a combination of option and shares exist that provides a risk-free payoff?

3. C = SN(d1) – Xe-rt N(d2) Calculating B-S Call Options • S = current market price of underlying stock • X = strike price of option • t = amount of time before option expires (in years) • r = annual risk-free interest rate • = annual standard deviation of underlying stock’s returns • e = 2.718 • N(X) = probability of drawing a value less than or equal to X from standard normal distribution

4. An Example • Price of Stock Holm Inc. is currently $28 • A European call option on Stock Holm Inc. has expiration date three months in the future and strike price of $25. • Estimate of standard deviation on Stock Holm Inc. is 40% and the risk-free rate is 3%. What should the call price be? • N(0.7041) = 0.7593 N(0.5041) = 0.6929 • C = 28(0.7593) – 25( 2.718-(.03)(0.25))(0.6929) = $4.07

5. 50 Call Price Now Call Payoff at expiration 45 40 35 30 Value of Call Option ($) 25 20 15 10 5 0 0 15 28 45 60 Stock Price ($) B-S Call Values for Stock Holm Inc.

6. Option’s Delta Measures how much the call price changes as the underlying stock price changes: • Delta is equal to the slope of the solid line in previous graph. • Delta equals the value N(d1) from B-S formula. • When call is far out of the money, delta is close to zero. • When call is deep in the money, delta is close to one. 1/N(d1) is equivalent to hedge ratio (h) from binomial model. • Investors who own Stock Holm Inc. stock and want to create a hedged portfolio need to sell roughly 1/N(d1) = 1.316 calls for each share in their portfolio.

7. Replace PV(X) with Xe-rt and C with Black-Scholes equation. Put option does not always sell for more than its intrinsic value, as can be observed on next slide. • If stock price is very low, almost certain that option will be exercised at expiration. • Amount by which put price falls below intrinsic value = time value of money investor loses by having to wait until expiration. Using B-S to Value Puts • Use put-call parity to determine the price of the put: S + P = PV(X) + C • P = Xe-rt [1 – N(d2)] – S [1 - N(d1)]

8. B-S Put Values for Stock Holm Inc. 50 Put Price Put Payoff 45 40 35 30 Value of Put Option ($) 25 20 15 10 5 0 0 15 28 45 60 75 Stock Price ($)

9. Can use historical data to estimate volatility: • Use daily data if stock traded frequently. • Otherwise, use weekly or monthly data. • From the observed price of an option in the market,we can compute implied volatility by “inverting” the B-S formula. • Studies showed that out-of-the-money options have higher implied volatility than at-the-money options. Implied volatility Volatility Speculative trading strategies seek to exploit differences in implied volatilities for a single underlying asset.

10. If firm’s assets are not sufficient to repay its debt at maturity, the firm puts its assets to the bondholders. Long Corporate Bond $250 Bond payoff at maturity 0 Value of assets at maturity $250 Options Embedded in Ordinary Corporate Bonds • Corporate bondholders have a position equivalent to a portfolio of risk-free debt and a short put option.

11. If firm’s assets are worth more than the value of its debt, the shareholders keep the surplus. Shareholders’ payoff 0 Value of assets at maturity $250 Options Embedded in the Stock of Levered Firm • Shareholders of a levered firm hold a call option.

12. Warrants • Securities issued by firms that grant the right to buy shares of stock at a fixed price for a given period of time 1. Warrants are issued by firms. Call options might be issued by other investors. 2. Number of outstanding shares increases when warrants are exercised. No new shares are issued when calls are exercised. 3. Warrants usually have longer maturities than options. 4. Firms frequently attach warrants to other securities they issue.The firm receives capital from warrants once when they are issued and again if they are exercised. Similar to call options, with some differences:

13. N1 : number of old shares outstanding • N2 : number new shares issued when warrants are exercised • An example… • On April 12, 2002, UQM Technology issued 1,160,095 additional shares at $4.31/share. • For every five shares, investors received a warrant with strike price of $5.73 and expiration date on April 12, 2004. Pricing Warrants • Use Black and Scholes model to price warrants. Must take into account dilution that occurs when firms issue new shares to warrant holders:

14. N(0.339) = 0.633 N(-0.750) = 0.226 • C = 4.40(0.633) – 5.73( 2.718-(.02)(2))(0.2263) = $1.54 Pricing Warrants • On April 12, 2002, UQM Technologies had 18,829,848 common shares outstanding after issuing new shares. • Stock price = $4.40; st. deviation = 77%; risk-free rate = 2%

15. Conversion ratio • Number of shares bondholders receive if they convert • Current stock price x conversion ratio • Provides lower bound on the market value of convertible bond Conversion value • For example… • Amgen Inc. issued in Feb 2002, a 30-year, zero-coupon convertible bonds with ytm of only 1.125%. • Price of convertible bond = $1,000/(1.01125)30 = $714.9 Convertibles • Convertible bonds grant the owner the option to convert the bonds for a certain number of shares. Investors accepted the low yield because they also received the option to convert each bond with face value of $1,000 into 8.8601 shares of Amgen.

16. Bond price/Value $714.9 0 $80.69 Stock Price The Value of an Amgen Convertible Bond

17. Company analyzes whether it should bid for oil drilling rights for one year on a tract of land. • Cost of extracting the oil is $18 per barrel. • Current and expected future price of oil is $16 per barrel. Real Options: Drilling Rights Example • Could use option models to determine the value of drilling rights: The right to drill is like a call option with exercise price of $18. • Assume volatility of the oil price is 30% and risk free rate is 4%. • Given this volatility, the firm can expect at some point the price of oil could rise to make drilling profitable. NPV approach gives a negative value for this project What if we take into consideration the volatility of oil prices?

18. C = $1.40 Real Options: Drilling Rights Example Initial approach: use B-S model to price the option Bid value: call option value x number of barrels expected in this field • B-S model is an oversimplification in this case: It assumes that the options can be exercised only at the end of the year. • More accurate approach: Use binomial model to price the option.

19. Uncertainties related to this project: • Level of sales the kiosk will achieve: Would costumers like to purchase McDonald's dessert products from the new locations? • The sensitivity of the McTreat Spot enterprise value to the overall economy Real Options: McTreat Spot Example McDonalds evaluates the possibility of investing in McTreat Spot, small kiosks offering ice cream and frozen yogurt. McDonald’s invests in a few product test stores in prime locations. What if McDonald’s launches program without testing?

20. NPV of McTreat Spot Compute NPV of the project • Potential market is evaluated at 1,000 storefronts. • Cost for setting up each storefront is $750,000: total investment of $750 million. • Rollout period is 2 years. • Management estimates the following outcomes: • With 0.4 probability, the project is a hit and generates free cash flow of $1.5 billion in two years. • With 0.6 probability, the project is a bust. PV of free cash flows in this case is $500 million in two years. • Management assigns a 13% discount rate to this project.

21. NPV of project NPV of McTreat Spot Immediate rollout would destroy shareholder value. McDonald’s can learn the value of the 1,000 store chain before investing $750 million by using the test program. How much should the company spend for the test program?

22. Test Program as a Call Option Investing in test stores is similar to a call option: • Underlying asset: the cash inflows from a 1,000-kiosks • Strike price: the $750 million needed to build the kiosk • McDonalds will exercise the optionif the testing program shows that value of the business is greater than $750 million.. Use binomial model to price the option: • Underlying asset is always what you get if you exercised the option: In June, 2001, estimated value of McTreat Spot is $704.8 million. • If value of the option is higher than the cost of the test stores (their negative NPV), invest in the test program. • Assume risk free rate is 5%.

23. June 2001 June 2003 Real option payoff Probability = 0.4 $1.5 billion $750 million $704.8 million Probability = 0.6 $500 million $0 Test Program as a Call Option • Use risk-neutral method • Expected return on the underlying asset is the risk-free rate. • Expected value of the asset in 2 years = $704.8(1.05)2 = $777.0. • p = risk-neutral probability of an up movement • 1 - p = the probability of a down move

24. Test Program as a Call Option • Expected payoff on underlying asset equals risk-free rate: • $1,500p + $500(1 – p) = $777 • p = 0.277 • 1 – p = 0.723. • Use risk-neutral probabilities to calculate expected cash flows in 2003 from the call option. • Expected cash flow from option = $750p + $0(1 – p)= $750(0.277) = $207.8 • PV of the call option = $207.8/(1.05)2 = $188.4 As long as the cost of the testing program is less than $188.4 million, McDonald’s should invest in it.

25. Black and Scholes and Beyond B-S formula can be used to value a European call on a stock that pays no dividends. Of the five inputs of the model, only volatility is an unknown that analysts need to estimate. Both debt and equity of a firm have option-like characteristics. Capital investments with option-like characteristics may be valued using binomial model or B-S model.