Corporate risk management and option techniques (Y05127)
Institution
Katholieke Universiteit Leuven (KU Leuven)
Full summary of corporate risk management: Part Frederiek Schoubben. Contains all slides, papers and notes during classes. Only this summary is needed to pass the exam. Grade: 17/20
corporate risk management and option techniques frederiek schoubben handelswetenschappen kuleuven option techniques real options y05127
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Katholieke Universiteit Leuven (KU Leuven)
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Corporate risk management and option techniques (Y05127)
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Option techniques
Exam:
True false questions
Exercises + “Spot the option” integrated case
SPOT THE OPTION: Case on the EXAM
o Story of investment and financiering
o A lot of options but a lot of people do not value all the options
o Spot where and what the option is
o Value the options
NPV is not completely irrelevant
NPV+: + = incorporate flexibility. Making the things more to real life. Normal NPV ignores a few
elements you could encounter in time.
INTRODUCTION: Options
(If anything about options, binomial or Black & Sholes is not clear: p5-15: promise_peril.pdf )
As a financial derivative:
Right to buy (call option) or sell (put option) the underlying asset at an agreed-upon price
during a certain period of time or on a specific date. The buyer pays a price for this right.
= contract = tradable
As a strategic concept:
Right to make (when favorable) or postpone (when not favorable) a strategic decision during
a certain period of time.
o Generates operational flexibility (<> take it or leave it)
o Creates value (optimizing decision making)
o Driving behavior (uncertainty increases option value)
Real options have no markets where they are traded: You may be the only one that finds an option
before everyone else:
Not everyone sees the option
You are in charge, the other party might not see that you are creating an option
Financial options:
Traded and there is a demand and supply
Spot the option: List the aspects that impact the option: these are the determinants of option value.
Current value of the underlying asset:
Changes in value of asset affect the value of the options on that asset. Example: Puts become
less valuable as the value of the asset increase.
Income generated by underlying asset
Strike price of the option:
Call: value of option declines when strike price increases.
Riskless interest rate corresponding to the life of the option:
Since the buyer of an option pays the price of the option up front, an opportunity cost is
involved. This cost will depend upon the level of interest rates and the time to expiration on
the option. Riskless interest rate is also used when the present value of the exercise price is
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, calculated, since the exercise price does not have to be paid (received) until expiration on
calls (puts). Increases in the interest rate will increase the value of calls and reduce the value
of puts.
Time to expiration of the option
Both calls and puts become more valuable as the time to expiration increases.
Volatility (uncertainty) in the value of underlying asset:
The higher the variance in the value of the underlying asset, the greater the value of the
option.
It is not yes or no the characteristics and the arguments you can give will determine if an option is
an option.
If you invest your money in a project, you cannot invest in other projects.
you should build in flexibility to adopt to changing conditions and other opportunities arise
Capital structure:
= debt and equity financing.
there are conflicts between debt and equity holders.
Who has the right to act and where?
1. Use explicit (implicit) options to attract financing
2. Use (implicit) options in investment analysis
3. Exercise (implicit) options to change operations
4. Exercise (implicit) options to change financing
5. Use options to optimize management behavior
Using option techniques you will be able to value certain decisions and understand certain behavior:
What is the value of postponing investment decisions?
How does uncertainty influence the value of flexibility?
Why are investment deals riddled with contract clauses?
..
Using option techniques, you will be able to assess the strengths and weaknesses of investment
analysis and financial decision making:
Valuing a decision means using assumptions about the future
Uncertainty means that predictions are always wrong
Uncertainty reduces present value but increases potential outcomes
Postponing a decision might provide more information
Postponing a decision means losing the initiative
There is a difference between known unknowns and unknown unknowns
The problem of uncertainty is that you can never get rid of it just by using options
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, the upper word mentions how to deal with these things.
Example: Unknown knowns: You know what is going to
happen when Brexit happens to some extent. But it is
unknown if it happens use sensitivity analysis
Unknown unknowns: black swans.
you need to be flexible.
Option techniques in investment
analysis:
Is risk an opportunity?
Known unknowns = risk
Unknown unknowns = uncertainty.
3 ways to cope with risk and uncertainty:
Analyze the risk to incorporate it in the investment analysis through cost of capital
The more riskier projects may not be selected based on the NPV: VB. TESLA
(CAPM WACC NPV)
Analyze the assumptions of the investment analysis based on perceived uncertainty
(sensitivity & break-even)
Allow for flexibility and make use of its value in relation to potential uncertainties
(real options)
See slide 26 part 1.
Investment process:
Cost of capital increases with risk:
CAPM: Re = Rf + beta*(Rm – Rf)
Present value reduces with risk
Traditional Metrics like NPV, IRR and ROI Kill Innovation
To make the number look good you have to:
Keep the denominator low
Focus on the short-term
Develop more of what makes money today
By doing this, you only invest in what makes money today, but not in what makes money tomorrow.
Game changing requires abandoning the risk<>return channel
Explore without expected return
Venture into the unknown
Allow failure
Traditional view:
3
, 1. Phase 1:
Overview of all investment opportunities (capital budgeting)
2. Phase 2:
Allocation of recourses to projects
new investments, unavoidable expenses, maintenance costs, ..
Traditional metrics not always applicable!
you need reliable expectations, there are conflicts of interest and biased assumptions.
A new paradigm is needed: option techniques might deliver that paradigm.
From financial options to real options: advanced real option
application
In situations where flexibility is important, NPV does not always provide the right solution:
Expanding operations
Abandoning operations
Timing of operations
Every definitive decision rules out future opportunities.
Flexibility means deciding while leaving certain (other) options on the table.
Real options provide this flexibility
Real option:
= the right to make a future corporate decisions (like an investment) during a certain time.
An additional expenditure is needed to get all future cash flows of the project.
Financial option: (CALL)
= the right to buy a certain financial asset (like a stock) at a predetermined price in the future.
Buy paying the strike price, you receive the asset (i.e., all its future cash flows)
Derivative securities:
= financial contracts that derive their value from other securities. They are also called contingent
claims because their payoffs are contingent of the prices of other securities.
Examples of underlying assets: common stock, foreign exchange rate, future contracts, ..
Examples of derivative securities: options (call/put), forward and future contracts, swaps, ..
serve as investment vehicles for:
• Hedgers (decrease the risk level of the portfolio)
• Speculators (increase the risk)
Long position in a stock: (=buying stock)
The payoff increases as the value (price) of the stock increases. The increase is one-for-one: for each
dollar increase in the price of the stock, the value of our position increases by one dollar.
See slide 39.
Short position in a stock: (=selling stock)
The payoff decreases as the value (price) of the stock increases. The decrease is one-for-one.
Note that the short position is a liability with a value equal to the price of the stock (mirror image of
the long position). See slide 41 + 42.
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