Example-1: Call Option

The stocks of of a firm closed at Rs. 300 per share yesterday. The stock also has
a call option on it traded on the same stock exchange with folowing features:
Today is: 17-Jan-2014
Strike Price 320 Rs. Per share
Expiry date 17-Apr-2014
Spot Price 300 Rs. Per share
What will you do? Buy the option? Sell the option?
Example - 2: Buying (Call) Option is Insurance
Example - 2: Buying (Call) Option is Insurance
Consider an European Option - you will decide
to exercise your right on the expiry date
Today is: 17-Jan-2014
Strike Price 320 Rs. Per share
Expiry date 17-Apr-2014
Case-A: Price on expiry date is 280
You exercise the option to buy, since
the strike price is lower than spot price.
You buy it at the strike price by exercising the option.
After buying the share under the option, you sell it in the spot market.
You make a gross profit of Rs. 40 per share
Case-B: Price on expiry date is 360
You don't exercise the option to buy
since the strike price is higher than spot price
You can easily buy it at the spot price.
So you don't buy the share under the option contract.
The call option expires un-exercised.
Example - 7: Valuing a Patent
A pharma company has developed a new drug to treat ulcers.
The company has also patented the drug, and has patent right
for next 20 years. Although the drug is very promising, it is
still very expensive to manufacture. Consequently, the price
of the drug is expected to be so high that it is expected to
command a very small market.
The initial investment to produce the drug is Rs. 50 crore,
and the PV of cash flows is currently estimated at Rs. 35 crore.
The technology is not yet stabilized, and due to the presence
of several competitors, including a few unbranded substitutes,
the market is volatile.
A simulation exercise has yielded a volatility (st.dev.) of
PV to be 25%.
Estimate the value of call option to delay the project, and
the cost of delay.
Solution-7
Given data:
o 0.25
o
2
0.0625
S (=V) 35
K (=X) 50
r 6% (assumed)
T - t 20 years (life of patent)
Therefore,
d
1
= 0.2937
d
2
= -0.8244
Consequently,
N(d
1
) = 0.6155 =NORMSDIST(d
1
)
N(d
2
) = 0.2049 =NORMSDIST(d
2
)
Cost of delay (=1/n)-percentage 5.0%
Value of call option to delay 4.84 Rs. Crore
Thus, though the new drug is a negative-NPV project today,
it still is valuable (in the sense of option to delay) to the firm.
( )
(

|
|
.
|

\
|
+ + |
.
|

\
|

= t T r
K
S
t T
d
2
ln
1
2
1
o
o
t T d d = o
1 2
( ) ( ) ( )
( ) t T r t T y
Ke d N Se d N t S C

=
2
) (
1
,