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Sir, option to redeploy is a real put option.
We know that a put option is only exercised when the value of the underlying asset is lower than the exercise price.
In the case of a real option:
Value of project (value of underlying asset) = PV of cash flows from the new activity (the activity in which funds would be redeployed)
Exercise price = Switching costs
Then why in the bpp book it says the switch from one activity to another will occur if the PV of cash flows from the new activity will exceed the switching costs. [This is the opposite of the main put option theory or this is exactly the call option theory]
Am I missing something here or one of my assumptions regarding values for the project is wrong.Although it is a put option (because you are effectively abandoning the existing activity and moving to a new one), think about the logic of it.
Why on earth would you consider switching to a new activity unless the PV of the benefits was more than the cost of switching? It would be stupid to switch if that were not the case 🙂
Sir, I definitely agree with your latter statement.
Your first one is logical too, but I’m talking about the math of it. If [Value of underlying asset>Excercise price] we exercise Call Options, but Put Options are the opposite. So this makes Option to redeploy a call option.
Ok lets look at this from a different point of view.
If we have an option to redeploy with the PV of the new activity, the costs of switching and all the other variables needed given in the question.
What would be the Pa and the Pe for the Black-Scholes formula??You would do the maths as though it was in fact a call option.
If you are referring to a question in the BPP Revision Kit (or to a past exam question) then say which one.
If it is a question in the Study Text then I can’t help you because I don’t have the BPP Study Text.I don’t think option to redeploy has been examined in the past, the BPP gives a reference to the year in which any topic was examined but it didn’t with this so…
Has it been examined?
Not that I remember (and if it is examined it is more likely to be just a description rather than a calculation).
Ok but if it is a calculation, am I right to assume, for the Black-Scholes formula, Pa as PV of cash flows of new activity and Pe as cost of switching?
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