About this video

• Video Title: AFM Topic Explainer: Application of option pricing theory in investment decisions
• Channel: ACCA Student Study Resources
• Speakers: Zikang Chan
• Duration: 00:32:13

Overview

This video explains how option pricing theory can be applied to investment decisions, particularly for projects that include "real options." It details what real options are, how to incorporate their value into investment appraisals like Net Present Value (NPV), and demonstrates how to calculate this value using models like the Black-Scholes model.

Key takeaways

• Understanding Real Options: Projects, especially large-scale ones, can include flexibilities that give the company a right, but not an obligation, to alter the project's course. These rights are called real options and can manifest as the option to delay, expand, or abandon a project.
• Valuing Flexibility: These real options carry value that should be incorporated into the investment appraisal. Projects with real options are expected to have a higher NPV than similar projects without them.
• Incorporating Real Option Value into NPV: To calculate the NPV of a project with real options, first calculate the NPV ignoring the options. Then, derive the value of the embedded option (call or put) and add it to the initial NPV.
• Option Pricing Models: The Black-Scholes Option Pricing model (BOP) and the Put-Call Parity (PCP) model are commonly used to estimate the value of these options. BOP is typically used for call options (rights to delay or expand), while PCP is often used for put options (right to abandon).
• BOP Model Inputs: The BOP model requires five key variables: the asset price (or present value of future cash flows), the exercise price (initial investment or selling price), time to maturity, volatility of cash flows, and the risk-free rate of interest.