Question Digunder December 2007 (amended per BPP)

Aat80011y ago

Dear Sir, Please clarify the following questions which are both related to identification of the Pa parameter of BS option pricing model for part (a). Intuitively, one can understand that Pa = 24 + 4 = 28 which is correct. 1) However why do we add to Pa the strike pirce (which is 24)? Thus, in case of question MMC June 2011 the Pa parameter does not include the strike price. 2) I did more than my intuition told me: Pa should be discounted to current value from the maturity date to the moment when the option is valued. Therefore, we should add 24 + 4 =28 and divide them by 1.1^2 as the period to maturity is 2 years. Thus, question states that NPV of the project is equal to 4 and it's not mentioned that the NPV estimation includes the 2 years to maturity of the project. Is it correct or one should just add 24 to 4 to get 28 as answer states? Thank you in advance.

John MoffatTutor11y ago#1

1 Both Digunder and MMC have treated it in the same way. In Digunder, Pa is the exercise price + the NPV of the project (which is correct). In MMC, although the examiner sets out the calculation a little bit different. The exercise price is 35, the the NPV is the PV of the flows after the 2 years (when it is exercisable) less the 35. i.e. 38.75 - 35 = 3.75. So Pa is 35 + 3.75 = 38.75 2 Discounting over the period to maturity is already effectively done in the Black and Scholes formula.

Aat80011y ago#2

1) So, finally Pa=(Pe+X)/Pe, where X is the return phase of the delayed investment (or other type of return phase depending on the option type envolved). Please confirm. 2) So, if the question states that 4 mln is PV, I should not do such excercises. As per exam technique, if it's mentioned that there is NPV of the project - one should just put it to the formula accordingly without additional discounting. Please confirm. Thank you in advance.

John MoffatTutor11y ago#3

1) Yes, although there is no real need to refer to it as the return phase. It is the flows that result if we exercise the option. 2) True :-)

Aat80011y ago#4

Thank you very much!

John MoffatTutor11y ago#5

You are welcome :-)

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