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Im quite confused over the “Pa” of the black-scholes formula.
If i’m calculating a share option i will be using the current share price.
a currency option, the spot price.i know Pa is the value of the underlying asset.
however, i have problem identifying the Pa in real options.
for example, for a abandonment option. Pa is the Pv of the cash flow foregone.
for a option to delay, Pa is NPV of project + exercise price which can be delay.whats the logic behind this?
No – for an option to delay, Pa for the formula is the PV of the cash flows.
Where I think you are getting confused, is that if there is no option to delay then the value of the project is simply the NPV. If, however, there is an option to delay then the project becomes more attractive and the value of it becomes higher and is the NPV + the value of the option.
(Incidentally, you mention valuing a currency option (which needs the Grabbe variant of Black Scholes) – this is no longer in the syllabus, it was removed a few years ago.)
Hi tutor, MayI know why does e real options to delay, the project become more attractive as stated in your comments?
If a project has a positive NPV then we normally say that it is worth doing. However a problem is that the cash flows will only be estimated and may turn out to be better but may turn out to be worse – for example, the economic climate over the next few years may be uncertain and may have a big effect on the estimated cash flows.
Usually we assume that if we do the project then we do it now, and have to stick with it even if things turn out to be bad.
If, however, we are able to delay starting the project (until we know better how well or badly it will do) or if we are able to abandon doing the project if things go bad, then we say that we have a real option. The ability to delay or abandon makes the project more attractive than if it was simply do it now and stick with it.
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