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Sleepless in L.A.

Case Analysis

March 5

2014
Submitted by, Anadi Kaistha Nabin Basha Naveen Kumar Sanoop S Sreenandan Nambiar P

1.

How can Black Scholes model is used in pricing the options? And what we understand by call and put options in the context of erton model?

The BS Model is one of the most important concepts in modern financial theor ! Blac" # Scholes$BS% model is not the most accurate one in pricin& the options' but is the closest and (idel used model (ith fe( assumptions and corrections! )t is re&arded as one of the best (a s of determinin& fair prices of options! Blac" # Scholes model prices the options b the BS formula (hich &ives the theoretical estimation of the *uropean options$+hich assumes that the should be held till e,piration! *,!' P*'-*%! B the above model the option pricin& can be done (ith fe( assumptions! . . . . . . No dividends paid until e,pir of the option /nl *uropean options are e,ercised Mar"ets are not predictable and efficient 0is" free rate are "no(n and constant 0eturns are lo&normall distributed -ommissions are not char&ed

)n the formula of Theoretical call premium$-%' first term SN$d1% &ives the e,pected profit b ac1uirin& a stoc"! Second term Ke$2rt%N$d2% &ives the P3 of pa in& the e,ercise price on e,piration! -all and put options in the conte,t of Merton model4 Merton model is used to evaluate the credit ris" b determinin& the compan 5s abilit to meet its financial obli&ations b servicin& its debt! /nl the residual cash flo(s are paid to the e1uit holders after clearin& all its debt obli&ations! Merton model determines the value of the e1uit of the levered firm (ith call option on firms asset as follo(s! 36 3alue of firm 763alue of debt -laim of e1uit 6 ma, $327'0% 3alue received b debt holders at an time t 6 min $7'3% 3alue of firm 6 ma, $327' 0% 8 min $7' 3% Similar option based analo& can be used to price the value of a firm5s debt! 7ebt is a put option on the compan 5s assets (ith the same stri"e price!

The premium on this option is the present value of the ield spread over and above the ris" free rate! 3alue of a firms ris" debt is the difference bet(een the ris" free debt and the put option on firm5s assets (ith stri"e price e1ual to same face value of debt!

!.

"eferring the case exhibit #, can you use the Black Scholes model to $erify the $alue of these publicl traded options9 7oes the model &ive the same value as the mar"et value9 +h or (h not9

Belo( are the values for call option calculated usin& the Blac" Scholes modes! The model does not &ive the same values as the mar"et values! The values in some cases are close to the mar"et values! There are fe( assumptions of the Blac"2Scholes model! The stoc" pa s no dividends durin& the option:s life *uropean e,ercise terms are used Mar"ets are efficient No commissions are char&ed )nterest rates remain constant and "no(n 0eturns are lo& normall distributed These assumptions do not hold true in the mar"et scenario and are prone to man fluctuations and chan&es! *,ample the assumption that mar"ets are efficient is one of the theoretical concepts (hich do not hold an si&nificance in the mar"et!

%all &ption 'rices()sing Black Scholes *,piration 7ate Stri"e Price 20 22!< 2< 2@!< 042;un

odel* 0427ec

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?!2> >!@= 1!>4 21!11

%all &ption 'rices( arket 'rices* *,piration 7ate Stri"e Price 20 22!< 2< 2@!< <!A0 >!40 1!2< !2< ?!20 4!00 2!1< !A0 ?!>0 <!00 2!< 1!40 042;un 042Sep 0427ec

'ut &ption 'rices()sing Black Scholes *,piration 7ate Stri"e Price 20 22!< 2< 2@!< 2<!=> 2>!>> 20!=> 1!?? 042;un

odel* 0427ec 2?!2> 2>!@= 21!>4 1!11

042Sep 2?!0> 2>!<? 21!0A 1!>=

'ut &ption 'rices( arket 'rices* *,piration 7ate Stri"e Price 20 22!< !0< !1< !20 !?0 !>< !?< 042;un 042Sep 0427ec

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+or"in& Sheet

Working Sleepless.xlsx

#.

%an option pricing help +ustify why

icrocomp,s market capitali-ation is not -ero?

Brom our vie( (e a&ree that option pricin& does help Custif (h Microcomp5s mar"et capitaliDation is no Dero! Microcomp5s outstandin& debts (ere E1<0!0 million (hile' the mar"et value of the firm $assets% (ere at E11<!< million! )n this case the mar"et capitaliDation should have &one to a Dero value! Fo(ever' it stood at E2?!< million! This ma be' (hen shareholders borro(ed mone b issuin& bonds' the actuall sold the firm or the part of the firm for cash but' also obtained an option to repurchase the firm at the time of maturit of the debt! The bond bu ers have a -all option on these bonds' (hich is a 0i&ht to sell the bond but' not an obli&ation to sell at the stri"e price! Fence' this facilit comes (ith a premium and thus &ives some value to bond! This in turn mi&ht have turned up the mar"et capitaliDation of Microcomp to E2?!< million! Alternativel ' investors5 future e,pectations that compan (ill perform (ell after a certain period of time can &ive some value to the mar"et capitaliDation! This factor mi&ht have considered (hile pricin& the option in the bond and hence &ave a value of E2?!< million on mar"et capitaliDation! The pricin& of a call option bond can e,plained (ith the help of Blac"2Scholes model! 3alue of call option 6 SGN$d1%KGeHr$T2t%GN$d2% 3alue of put option 6 KGeHr$T2t%GN$2d2%SGN$2d1% +here' d1 6 lnSK8r812I2G$T2t%IGT2t d2 6 d1 2 IGT2t S J 3alue of underl in& share

K J *,ercise price of the option r J 0is" free rate T2t J 0emainin& time to maturit I2 J 3ariance of share price N$!% 2 -umulative distribution function of the standard normal distribution Ksin& this formula' a future &ain in price can be predicted and accordin& to that a probabilit of &ood performance is e,pected from the firm and hence a mar"et capitaliDation value of E2?!< million! LLMar"et capitaliDation is the product of mar"et value per share and the outstandin& shares!

..

%an options pricing be used to $alue

icrocomp,s risky bonds and How?

The -ompan has assets that are financed (ith bonds and e1uit ! The bonds mature in 2 ears at (hich time a principal pa ment of E1<0 mn is re1uired! )f the assets are more than E1<0 mn in 2 ears' the e1uit holders choose to repa the bondholders! Fo(ever in this case the mar"et value of assets is less than repa ment value of the bonds $reflectin& financial distress%' it has to choose ban"ruptc and the bondholder end up in o(nin& the compan ! The value of e1uit in 2 ears is therefore a ma, of $AT2K' 0%' (here AT is the value of the compan 5s assets and K is the principal pa ment of the bond at that time! This sho(s that the e1uit holders have a 22 ear *uropean call option on the assets of the compan (ith stri"e price of K! The bondholders &et min$AT' K% in 2 ears! This is the same as K J ma, $K2AT' 0% (hich sho(s that toda the bonds are (orth the present value of K minus the vale of a 22 ear *uropean put option on the assets (itha stri"e price of K! )f - and P are the value of call and put options on ht e -ompan 5s assets at time T' then 3alue of e1uit 6 - # 3alue of debt 6 P3$K% JP )f A0 is the value of assets toda ' then it (ill be e1ual the total value of the instruments used to finance the assets! Summarisin& the above statement the e1uation (ould be' A06 - 8 MP3$K% J PN 6O - 8 P3$K% 6 A0 8 P The above e1uation (ould result in put2call parit and thus option pricin& can be used for pricin& of the bonds!