Options Theory And Strategic Investment Decisions

Abstract

Abstract This paper discusses use of options pricing theory far evaluating long-term capital investments. Specifically, what is the optimum expenditure level required to create an investment option? Can the Black & Scholes option pricing model be used to determine the approximate option value? This concept may have value to the petroleum industry in western Canada. Many oil companies have made strategic investments that could probably not have been justified by using standard economic analysis. The authors are unaware of any commonly used methodology to evaluate strategic investments. This paper includes a discussion of the variables in the Black & Scholes model to value having the option to develop hypothetical oil sands projects. The analysis will include consideration of the mode/'s limitations and the difficulties of applying it in a corporate setting. Introduction Options are specialized financial vehicles whose values are contingent upon those of other securities. The purchaser of a European call (or put) option obtains the right to buy (or sell) a specific asset, at a set price, on a predetermined date. American options can be exercised on or before the specified dare. In the case of a call option, the purchaser is betting that the price of a security will increase above a specified amount (exercise price) by a given expiry dare. The seller of the option uses the proceeds as additional revenue and is betting that the price will not rise significantly. Options are commonly used in financial and commodity markets to hedge, reduce risk and speculate. Investors typically want to lock in prices, exchange rates, interest rates or guard against portfolio losses. Options have been traded for many years, but with the creation of the Chicago Board Options Exchange in 1973 these transactions became relatively easy and inexpensive. Options trading has seen a tremendous increase in volume and complexity, since that time. Black & Scholes Option Pricing Model A development which added to the success of options trading was the publication of a theoretical options pricing model by Fisher Black and Myron Scholes(l). The model was empirically validated shortly after publication. Given the assumptions of unrestricted, frictionless markets, and continuous trading/stock prices, Black & Scholes were able to demonstrate that synthetic option can be created from portfolios containing the underlying stock and risk free debt. The primary attraction of the Black & Scholes model is that the required input data are relatively easy to obtain. Neither expected rates of return nor assumptions about individual investor risk preferences are required. Those inputs that are required are cit her directly observable or can be estimated from historical data. Black & Scholes used the following equation to describe the value of a European call option: Equation 1 (available in full paper) The value of any option can be described by a variation of this fundamental equation. Black & Scholes solved equation (1) using the following boundary and terminal conditions. Equation 1a-1c (available in full paper)