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Q36 DIGUNDER Kaplan AFM Exams Kit
“Pa is the current price of the underlying asset
Pe is the exercise price
r is the continuously compounded risk-free rate
t is the time to expiration measured as a fraction of one year, for example t =0.5 means that the
time to expiration is six months.
e is the base of the natural logarithms” (BPP Advanced Financial Management)Per BPP, Pa stands for Current Price of the underlying asset (In this case the current price of the land). In contrast, the present value of the project cash inflows, rather than the current price of the land, of $23.13 million was assigned to Pa.
My question is, why has the present value of the project cash inflows been assigned to Pa rather than assigning the current price of land?
Please help me Sir. Thanks in advance
Pa is the current value (i.e. the PV of the cash flows).
Think about it. If it was not for the uncertainty and for the timings as to when we can exercise, then the value would be Pa – Pe, which makes sense. (If you could buy something for 100 (Pe) which had a PV of 150 (Pa), then the option would be worth 150 – 100 = 50.
The extra terms in the formula are to account for the uncertainty and for the timing.Our free lectures on share options and on real options explain this.
(In the case of share options, the current value (Pa) is of course the current share price because the share price is the PV of the future cash flows.)
Your concise explanation has helped to straighten my understanding about Option Pricing. Thank you very much Sir.
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