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Problem Set 4
a) In order to obtain the value of a European Call option (one year), we need to
take into account the following expression:
𝑂𝐶 = [𝑁(𝑑1 )×𝑃] − [𝑁(𝑑2 )×𝑃𝑉(𝐸𝑋)]
Data: P = 35
EX = 50 Rf = 0.03
σ = 0.2 T=1
We need to calculate:
PV(EX) = 50 x e-1*0.03 = 48.522277
ln(35/48.522277) 0.2√1
d1 = + = -1.53337
0.2√1 2
N(d1) = 0.062592
d2 = -1.53337 – 0.2√1 = -1.73337
N(d2) = 0.041515
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
0.176332 x 100 = $17.63
ln(35/48.522277) 0.5√1
d1 = + = -0.40335
0.5√1 2
N(d1) = 0.343345
1
N(d2) = 0.18317
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
ln(35/45.696559) 0.2√3
d1 = + = -0.34446
0.2√3 2
N(d1) = 0.365251
N(d2) = 0.244824
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
ln(35/24.261138) 0.2√1
d1 = + = 1.932361
0.2√1 2
N(d1) = 0.973343
1
d2 = 1.932361 – 0.2√1 = 1.732361
N(d2) = 0.958395
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
ln(35/33.965594) 0.2√1
d1 = + = 0.25
0.2√1 2
N(d1) = 0.598706
N(d2) = 0.519939
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
ln(60/48.522277) 0.2√1
d1 = + = 1.161608
0.2√1 2
N(d1) = 0.877303
2
d2 = 1.161608 – 0.2√1 = 0.961608
N(d2) = 0.831877
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
ln(35/47.088227) 0.2√1
d1 = + = -1.38337
0.2√1 2
N(d1) = 0.083275
N(d2) = 0.056668
Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
Assuming that we are comparing the values obtained with an option whose
exercise price = $50, σ = 0.2, r = 3%, t = 1 and stock price = $35, we find that the value
increases when the distance until maturity increases, as well as when volatility
increases. The call option goes from $0.18 to $1.60 and $3.13, respectively.
Regarding the following situations, we find that when the exercise price goes up
to $25 (ceteris paribus), the value of our option increased to $10.82. The same happens
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when in the third situation presented, the exercise price becomes $35, passing the call
value to be $3.29.
In the event that the stock price increases from $60, we see that there is an
increase in the value of our call, as well as when the value of the risk-free rate increases,
presenting the following values: $12.27 and $0.25, respectively.
Given the above conclusions, we can verify that there are variables that influence
the behavior of call options. These values when:
1) the value of the exercise price decreases;
2) the value of the stock increases;
3) the volatility of the option increases;
4) the risk-free rate increases;
5) the distance to maturity is increasing (more risk, more associated value).
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The value of Put Price on 100 shares of XYZ corporation is:
12.292772 x 100 = $1229.28
5
The value of Put Price on 100 shares of XYZ corporation is:
12.33445 x 100 = $1233.45
Given that we are calculating the value of the Put option, associated with the Call
option value, the base values are the same (exercise price = $50, σ = 0.2, r = 3%, t = 1
and stock price = $35). In this way, we verify that the behavior of the Put option will only
be equal to the Call option, when the volatility increases, that is, its value will increase,
going from $13.70 to $16.65.
In all other cases, the value of Put option will decrease: when the distance to
maturity increases, the Put option will have a value of $12.29; when the exercise price
decreases to $25 it has a value of $0.08, whereas when the exercise price is $35, Put
option has a value of $2.26; In the event that the share price increases to $60, the value
of the put option will be $0.80; and finally, if the risk-free rate increases to 6%, Put option
will present a value of $12.33.
In short, we can verify that, as there are variables that influence the behavior of
call options, there are also variables that will induce the behavior of put options. These
devalues when:
1) the value of the exercise price decreases;
2) the value of the stock increases;
3) the volatility of the option shows a decrease;
4) the risk-free rate increases;
5) the distance to maturity is increasing (more risk, more associated value).
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Problem 2
The first two years of the Project Alpha are presented in the following tree:
As the value of the project at this phase is negative, it does not seem to us that
any investment should be made.
b) If we are at time zero, once and for all, the phase 2 opportunity would be:
As the value of the project at this phase is negative, it does not seem to us that
any investment should be made.
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c) If we consider whether or not to invest in phase 2, the total value of the alpha
project is represented by the following expression
100 100 0,50 × (144+96)
NPV = [ − 100 + 1.10] + 0.5 × [− + ] = −$4.96
1.10 1.102
Taking into account the result obtained, it does not seem to us that the first
investment of $ 100 should be made, because the NPV will be negative.
d) The first two years of the Project Omega are presented in the following tree:
So, if we invest $100 today and only consider the phase 1 cash flows, we obtain as
value of Omega phase 1:
0,5 𝑥 140+0,5 𝑥 60
NPV phase 1 = -100 + = −100 + 90.91 = −$9.09
1.10
As can be seen, the NPV values obtained do not differ from those obtained in item
a) and b), since they do not differ in the expected value.
In relation to the resolution of the proposed statement, we see that the total value
of the Omega project is different ($3.31Project Omega > -$4.96Project Alpha) since the values
obtained depend on the volatility of the project in question (volatility differs from
project to project). Therefore, the first investment of $ 100 must be made.
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e) As we can see, both projects have a basic structure and the same risk system,
varying only one issue of cash flows (inflows obtained at the moment 1 different as well
as percentage of gain). Given the above statement, we can conclude that the option to
invest in one project and not the other is related to payoffs volatility.
When analyzing the structure of the payoffs obtained in the Alpha Project, we find
that it is not interesting since in all our options we have always obtained a negative
value, that is, a loss. In our perspective, the first case analyzed seems to be riskier, the
second being the most valuable since, when we wait and study the situation before
investing the first $ 100, the NPV of the Omega project is positive.
Regarding the possibility of financing both projects and taking into account that
investors are risk averse, the amount invested in Alpha would be lower than the amount
invested in Omega. This decision is based on obtaining superior returns when we make
the first investment in Omega. Although it does not seem to us so attractive to invest in
Alpha, it may acquire value in the market and change the structure of cash flows.
In conclusion, let's not forget that we are looking at our options based on a
discount rate that is used by the industry in question (with an approach that values the
expansion option) rather than a risk-free rate. Thus, the problem in question should be
solved with a risk-free discount rate (approaching the probability of neutral risk).