Option Pricing Theory and Applications

Aswath Damodaran

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 ˜hat is an option?

 An option provides the holder with the 
 to buy or sell a specified quantity
of an underlying asset at a fixed price (called a strike price or an exercise
price) at or before the expiration date of the option.
 0ince it is a right and Ô Ô

 ÔG the holder can choose not to exercise
the right and allow the option to expire.
 There are two types of options - R options (right to buy) and  options
(right to sell).

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 £all Options

 A call option gives the buyer of the option the right to buy the underlying asset
at a fixed price (strike price or K) at any time prior to the expiration date of
the option. The buyer pays a price for this right.
 At expirationG

f the value of the underlying asset (0) > 0trike Price(K)
± Buyer makes the difference: 0 - K

f the value of the underlying asset (0) < 0trike Price (K)
± Buyer does not exercise
 More generallyG
the value of a call increases as the value of the underlying asset increases
the value of a call decreases as the value of the underlying asset decreases

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 Payoff Diagram on a £all

Net Payoff
on £all

0trike
Price

Price of underlying asset

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 Put Options

 A put option gives the buyer of the option the right to sell the underlying asset
at a fixed price at any time prior to the expiration date of the option. The buyer
pays a price for this right.
 At expirationG

f the value of the underlying asset (0) < 0trike Price(K)
± Buyer makes the difference: K-0

f the value of the underlying asset (0) > 0trike Price (K)
± Buyer does not exercise
 More generallyG
the value of a put decreases as the value of the underlying asset increases
the value of a put increases as the value of the underlying asset decreases

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 Payoff Diagram on Put Option

Net Payoff
On Put

0trike
Price
Price of underlying asset

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 Determinants of option value

 6ariables Relating to Underlying Asset

6alue of Underlying Asset; as this value increasesG the right to buy at a fixed price
(calls) will become more valuable and the right to sell at a fixed price (puts) will
become less valuable.
6ariance in that value; as the variance increasesG both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
xpected dividends on the assetG which are likely to reduce the price appreciation
component of the assetG reducing the value of calls and increasing the value of puts.
 6ariables Relating to Option
0trike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
ife of the Option; both calls and puts benefit from a longer life.
 evel of
nterest Rates; as rates increaseG the right to buy (sell) at a fixed price
in the future becomes more (less) valuable.

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 A 0ummary of the Determinants of Option 6alue


   
  

ncrease in 0tock Price
ncreases Decreases

ncrease in 0trike Price Decreases
ncreases

ncrease in variance of underlying asset
ncreases
ncreases

ncrease in time to expiration
ncreases
ncreases

ncrease in interest rates
ncreases Decreases

ncrease in dividends paid Decreases
ncreases

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. 6aluing Natural Resource Options/ Firms


n a natural resource investmentG the underlying asset is the resource and the
value of the asset is based upon two variables - the quantity of the resource
that is available in the investment and the price of the resource.

n most such investmentsG there is a cost associated with developing the
resourceG 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.
 Defining the cost of development as XG and the estimated value of the resource
as 6G the potential payoffs on a natural resource option can be written as
follows:
Payoff on natural resource investment =6-X if 6 > X
=0 if 6 X

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 Payoff Diagram on Natural Resource Firms

Net Payoff on
xtraction

£ost of Developing
Reserve

6alue of estimated reserve

of natural resource

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 stimating
nputs for Natural Resource Options

nput stimation r ocess

1. Value of aila le Reser es of t e Resour ce ! §
er t esti ates (Ge l ists f r il..); e

r ese t al e f t e after -ta cas fl s fr
t e r es r ce ar e t e esti ate .
2. C st f e el
i eser e (Str i e r ice) ! ast c sts a t e s
ecifics f t e i est e t

3. i e t §
ir ati ! eli s e t er i : if asset as t e

4. Var iae i ale f er l i asset
r eli is e at a
i t i ti e.
! i e t e a st i e tr - ase

ietr a ca
acit t
t.
! ase 
 ar ia ilit f te
r ie f te
r esr es a ar ia ilit f aaila le r eser es.

5. et r ti eee ( iie Yiel) ! et
r ti r eee eer ear as
er et
f ar et ale.

6. eel

et La ! Callate
r eset ale f r eser e ase 

te la .

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 6aluing an Oil Reserve

 £onsider an offshore oil property with an estimated oil reserve of 0 million

barrels of oilG where the present value of the development cost is $ per
barrel and the development lag is two years.
 The firm has the rights to exploit this reserve for the next twenty years and the
marginal value per barrel of oil is $ per barrel currently (Price per barrel -
marginal cost per barrel).
 Once developedG the net production revenue each year will be % of the value
of the reserves.
 The riskless rate is 8% and the variance in ln(oil prices) is 0.0 .

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nputs to Option Pricing Model

 £urrent 6alue of the asset = 0 = 6alue of the developed reserve discounted

back the length of the development lag at the dividend yield = $ * 0
/( .0 ) = $ .
 (
f development is started todayG the oil will not be available for sale until two
years from now. The estimated opportunity cost of this delay is the lost
production revenue over the delay period. HenceG the discounting of the
reserve back at the dividend yield)
 xercise Price = Present 6alue of development cost = $ * 0 = $ 00 million
 Time to expiration on the option = 0 years
 6ariance in the value of the underlying asset = 0.0
 Riskless rate =8%
 Dividend ield = Net production revenue / 6alue of reserve = %

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 6aluing the Option

 Based upon these inputsG the Black-0choles model provides the following
value for the call:
d = .0 9 N(d ) = 0.8 98
d = 0. N(d ) = 0. 0 0
 £all 6alue= . exp(-0.0 )( 0) (0.8 98) - 00 (exp(-0.08)( 0) (0. 0 0)= $
97.08 million
 This oil reserveG though not viable at current pricesG still is a valuable property
because of its potential to create value if oil prices go up.

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 xtending the option pricing approach to value natural
resource firms

 0ince the assets owned by a natural resource firm can be viewed primarily as
optionsG    RÔ

 Ô
  ԏ R Ô
models.
 The preferred approach would be to R Ô R  Ô G value it
and cumulate the values of the options to get the firm value.
 0ince this information is likely to be   R 
 Ô for large natural
resource firmsG such as oil companiesG which own hundreds of such assetsG a
variant is to value the entire firm as one option.
 A purist would probably disagreeG arguing that
 Ô
Ô  Ô Ô
        Ô  R  
 
Ô

 Ô
      Ô (which is what the natural resource firm really
own). NeverthelessG the value obtained from the model still provides an
interesting perspective on the determinants of the value of natural resource
firms.

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nputs to the Model

è


 


 
   
6alue of underlying asset
xercise Price
Time to expiration on option
Riskless rate
6ariance in value of asset
Dividend yield
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6alue of cumulated estimated reserves of the
resource owned by the firmG discounted back at the
dividend yield for the development lag.
stimated cumulated cost of developing estimated
reserves
Average relinquishment period across all reserves
owned by firm (if known) or estimate of when
reserves will be exhaustedG given current
production rates.
Riskless rate corresponding to life of the option
6ariance in the price of the natural resource
stimated annual net production revenue as
percentage of value of the reserve.
 6aluing ulf Oil

 *ulf Oil was the target of a takeover in early 98 at $70 per share (
t had
. 0 million shares outstandingG and total debt of $9.9 billion).

t had estimated reserves of 0 8 million barrels of oil and the average cost of
developing these reserves was estimated to be $ 0 a barrel in present value
dollars (The development lag is approximately two years).
 The average relinquishment life of the reserves is years.
 The price of oil was $ . 8 per barrelG and the production costG taxes and
royalties were estimated at $7 per barrel.
 The bond rate at the time of the analysis was 9.00%.
 *ulf was expected to have net production revenues each year of
approximately % of the value of the developed reserves. The variance in oil
prices is 0.0 .

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 6aluing Undeveloped Reserves

6alue of underlying asset = 6alue of estimated reserves discounted back for period
of development lag= 0 8 * ($ . 8 - $7) / .0 = X

xercise price = stimated development cost of reserves = 0 8 * $ 0 = X
  Ô
Time to expiration = Average length of relinquishment option = 

6ariance in value of asset = 6ariance in oil prices = 
Riskless interest rate = 
Dividend yield = Net production revenue/ 6alue of developed reserves = 
 Based upon these inputsG the Black-0choles model provides the following
value for the call:
d = . 8 N(d ) = 0.9 0
d = .0 8 N(d ) = 0.8
 £all 6alue= G80. exp(-0.0 )( ) (0.9 0) -0G80 (exp(-0.09)( )
(0.8 )= X
  Ô

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 6aluing *ulf Oil


n additionG *ulf Oil had free cashflows to the firm from its oil and gas
production of $9 million from already developed reserves and these
cashflows are likely to continue for ten years (the remaining lifetime of
developed reserves).
 The present value of these developed reservesG discounted at the weighted
average cost of capital of . %G yields:
6alue of already developed reserves = 9 ( - . - 0)/. =$ 0 .8
 Adding the value of the developed and undeveloped reserves
6alue of undeveloped reserves = $ G0 million
6alue of production in place = $ G0 million
Total value of firm = $ 8G7 million
ess Outstanding Debt = $ 9G900 million
6alue of quity = $ 8G7 million
6alue per share = $ 8G7 / . =$ .

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