The Real Options Approach to Valuation: Challenges and Opportunities
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Section 1256 and Foreign Currency Derivatives
Section 1256 and Foreign Currency Derivatives Viva Hammer1 Mark-to-market taxation was considered “a fundamental departure from the concept of income realization in the U.S. tax law”2 when it was introduced in 1981. Congress was only game to propose the concept because of rampant “straddle” shelters that were undermining the U.S. tax system and commodities derivatives markets. Early in tax history, the Supreme Court articulated the realization principle as a Constitutional limitation on Congress’ taxing power. But in 1981, lawmakers makers felt confident imposing mark-to-market on exchange traded futures contracts because of the exchanges’ system of variation margin. However, when in 1982 non-exchange foreign currency traders asked to come within the ambit of mark-to-market taxation, Congress acceded to their demands even though this market had no equivalent to variation margin. This opportunistic rather than policy-driven history has spawned a great debate amongst tax practitioners as to the scope of the mark-to-market rule governing foreign currency contracts. Several recent cases have added fuel to the debate. The Straddle Shelters of the 1970s Straddle shelters were developed to exploit several structural flaws in the U.S. tax system: (1) the vast gulf between ordinary income tax rate (maximum 70%) and long term capital gain rate (28%), (2) the arbitrary distinction between capital gain and ordinary income, making it relatively easy to convert one to the other, and (3) the non- economic tax treatment of derivative contracts. Straddle shelters were so pervasive that in 1978 it was estimated that more than 75% of the open interest in silver futures were entered into to accommodate tax straddles and demand for U.S. -
Lecture 5 an Introduction to European Put Options. Moneyness
Lecture: 5 Course: M339D/M389D - Intro to Financial Math Page: 1 of 5 University of Texas at Austin Lecture 5 An introduction to European put options. Moneyness. 5.1. Put options. A put option gives the owner the right { but not the obligation { to sell the underlying asset at a predetermined price during a predetermined time period. The seller of a put option is obligated to buy if asked. The mechanics of the European put option are the following: at time−0: (1) the contract is agreed upon between the buyer and the writer of the option, (2) the logistics of the contract are worked out (these include the underlying asset, the expiration date T and the strike price K), (3) the buyer of the option pays a premium to the writer; at time−T : the buyer of the option can choose whether he/she will sell the underlying asset for the strike price K. 5.1.1. The European put option payoff. We already went through a similar procedure with European call options, so we will just briefly repeat the mental exercise and figure out the European-put-buyer's profit. If the strike price K exceeds the final asset price S(T ), i.e., if S(T ) < K, this means that the put-option holder is able to sell the asset for a higher price than he/she would be able to in the market. In fact, in our perfectly liquid markets, he/she would be able to purchase the asset for S(T ) and immediately sell it to the put writer for the strike price K. -
Futures and Options Workbook
EEXAMININGXAMINING FUTURES AND OPTIONS TABLE OF 130 Grain Exchange Building 400 South 4th Street Minneapolis, MN 55415 www.mgex.com [email protected] 800.827.4746 612.321.7101 Fax: 612.339.1155 Acknowledgements We express our appreciation to those who generously gave their time and effort in reviewing this publication. MGEX members and member firm personnel DePaul University Professor Jin Choi Southern Illinois University Associate Professor Dwight R. Sanders National Futures Association (Glossary of Terms) INTRODUCTION: THE POWER OF CHOICE 2 SECTION I: HISTORY History of MGEX 3 SECTION II: THE FUTURES MARKET Futures Contracts 4 The Participants 4 Exchange Services 5 TEST Sections I & II 6 Answers Sections I & II 7 SECTION III: HEDGING AND THE BASIS The Basis 8 Short Hedge Example 9 Long Hedge Example 9 TEST Section III 10 Answers Section III 12 SECTION IV: THE POWER OF OPTIONS Definitions 13 Options and Futures Comparison Diagram 14 Option Prices 15 Intrinsic Value 15 Time Value 15 Time Value Cap Diagram 15 Options Classifications 16 Options Exercise 16 F CONTENTS Deltas 16 Examples 16 TEST Section IV 18 Answers Section IV 20 SECTION V: OPTIONS STRATEGIES Option Use and Price 21 Hedging with Options 22 TEST Section V 23 Answers Section V 24 CONCLUSION 25 GLOSSARY 26 THE POWER OF CHOICE How do commercial buyers and sellers of volatile commodities protect themselves from the ever-changing and unpredictable nature of today’s business climate? They use a practice called hedging. This time-tested practice has become a stan- dard in many industries. Hedging can be defined as taking offsetting positions in related markets. -
Faqs on Straddle Contracts – Currency Derivatives
FAQs on Straddle Contracts FAQs on Straddle Contracts – Currency Derivatives 1. What is meant by a Straddle Contract? Straddle contracts are specialised two-legged option contracts that allow a trader to take positions on two different option contracts belonging to the same product, at the same strike price and having the same expiry. 2. What are the components of a Straddle contract? A straddle contract comprises of two individual legs, the first being the call option leg and the second being the put option leg, having same strike price and expiry. 3. In which segment will Straddle contracts be offered? To start with, straddle contracts will be offered in the Currency Derivatives segment. 4. What will be the market lot of the straddle contract? Market lot of a straddle contract will be the same as that of its corresponding individual legs i.e. the market lot of the call option leg and the put option leg. 5. What will be the tick size of the straddle contract? Tick size of a straddle contract will be the same as that of its corresponding individual legs i.e. the tick size of the call option leg and the put option leg. 6. For which expiries will straddle contracts be made available? Straddle contracts will be made available on all existing individual option contracts - current, near, & far monthly as well as quarterly and half yearly option contracts. 7. How many in-the-money, at-the-money and out-of-the-money contracts will be available? Minimum two In-the-Money, two Out-of-the-Money and one At-the-Money straddle contracts will be made available. -
Implied Volatility Modeling
Implied Volatility Modeling Sarves Verma, Gunhan Mehmet Ertosun, Wei Wang, Benjamin Ambruster, Kay Giesecke I Introduction Although Black-Scholes formula is very popular among market practitioners, when applied to call and put options, it often reduces to a means of quoting options in terms of another parameter, the implied volatility. Further, the function σ BS TK ),(: ⎯⎯→ σ BS TK ),( t t ………………………………(1) is called the implied volatility surface. Two significant features of the surface is worth mentioning”: a) the non-flat profile of the surface which is often called the ‘smile’or the ‘skew’ suggests that the Black-Scholes formula is inefficient to price options b) the level of implied volatilities changes with time thus deforming it continuously. Since, the black- scholes model fails to model volatility, modeling implied volatility has become an active area of research. At present, volatility is modeled in primarily four different ways which are : a) The stochastic volatility model which assumes a stochastic nature of volatility [1]. The problem with this approach often lies in finding the market price of volatility risk which can’t be observed in the market. b) The deterministic volatility function (DVF) which assumes that volatility is a function of time alone and is completely deterministic [2,3]. This fails because as mentioned before the implied volatility surface changes with time continuously and is unpredictable at a given point of time. Ergo, the lattice model [2] & the Dupire approach [3] often fail[4] c) a factor based approach which assumes that implied volatility can be constructed by forming basis vectors. Further, one can use implied volatility as a mean reverting Ornstein-Ulhenbeck process for estimating implied volatility[5]. -
Real Options Valuation As a Way to More Accurately Estimate the Required Inputs to DCF
Northwestern University Kellogg Graduate School of Management Finance 924-A Professor Petersen Real Options Spring 2001 Valuation is at the foundation of almost all finance courses and the intellectual foundation of most valuation methods which we will examine is discounted cashflow. In Finance I you used DCF to value securities and in Finance II you used DCF to value projects. The valuation approach in Futures and Options appeared to be different, but was conceptually very similar. This course is meant to expand your knowledge of valuation – both the intuition of how it should be done as well as the practice of how it is done. Understanding when the two are the same and when they are not can be very valuable. Prerequisites: The prerequisite for this course is Finance II (441)/Turbo (440) and Futures and Options (465). Given the structure of the course, no auditors will be allowed. Course Readings: Course Packet for Finance 924 - Petersen Warning: This is a relatively new course. Thus you should expect that the content and organization of the course will be fluid and may change in real time. I reserve the right to add and alter the course materials during the term. I understand that this makes organization challenging. You need to keep on top of where we are and what requirements are coming. If you are ever unsure, ASK. I will keep you informed of the schedule via the course web page. You should check it each week to see what we will cover the next week and what assignments are due. -
307439 Ferdig Master Thesis
Master's Thesis Using Derivatives And Structured Products To Enhance Investment Performance In A Low-Yielding Environment - COPENHAGEN BUSINESS SCHOOL - MSc Finance And Investments Maria Gjelsvik Berg P˚al-AndreasIversen Supervisor: Søren Plesner Date Of Submission: 28.04.2017 Characters (Ink. Space): 189.349 Pages: 114 ABSTRACT This paper provides an investigation of retail investors' possibility to enhance their investment performance in a low-yielding environment by using derivatives. The current low-yielding financial market makes safe investments in traditional vehicles, such as money market funds and safe bonds, close to zero- or even negative-yielding. Some retail investors are therefore in need of alternative investment vehicles that can enhance their performance. By conducting Monte Carlo simulations and difference in mean testing, we test for enhancement in performance for investors using option strategies, relative to investors investing in the S&P 500 index. This paper contributes to previous papers by emphasizing the downside risk and asymmetry in return distributions to a larger extent. We find several option strategies to outperform the benchmark, implying that performance enhancement is achievable by trading derivatives. The result is however strongly dependent on the investors' ability to choose the right option strategy, both in terms of correctly anticipated market movements and the net premium received or paid to enter the strategy. 1 Contents Chapter 1 - Introduction4 Problem Statement................................6 Methodology...................................7 Limitations....................................7 Literature Review.................................8 Structure..................................... 12 Chapter 2 - Theory 14 Low-Yielding Environment............................ 14 How Are People Affected By A Low-Yield Environment?........ 16 Low-Yield Environment's Impact On The Stock Market........ -
Evaluating the Performance of the WTI
An Evaluation of the Performance of Oil Price Benchmarks During the Financial Crisis Craig Pirrong Professor of Finance Energy Markets Director, Global Energy Management Institute Bauer College of Business University of Houston I. IntroDuction The events of late‐summer, 2008 through the spring of 2009 have attracted considerable attention to the performance of oil price benchmarks, most notably the Chicago Mercantile Exchange’s West Texas Intermediate crude oil contract (“WTI” or “CL” hereafter) and ICE Futures’ Brent crude oil contract (“Brent futures” or “CB” hereafter). In particular, the behavior of spreads between the prices of futures contracts of different maturities, and between futures prices and cash prices during the period following the Lehman Brothers collapse has sparked allegations that futures prices have become disconnected from the underlying cash market fundamentals. The WTI contract has been the subject of particular criticisms alleging the unrepresentativeness of the Midcontinent market as a global price benchmark. I have analyzed extensive data from the crude oil cash and futures markets to evaluate the performance of the WTI and Brent futures contracts during the LH2008‐FH2009 period. Although the analysis focuses on this period, it relies on data extending back to 1990 in order to put the performance in historical context. I have also incorporated some data on physical crude market fundamentals, most 1 notably stocks, as these are essential in providing an evaluation of contract performance and the relation between pricing and fundamentals. My conclusions are as follows: 1. The October, 2008‐March 2009 period was one of historically unprecedented volatility. By a variety of measures, volatility in this period was extremely high, even compared to the months surrounding the First Gulf War, previously the highest volatility period in the modern oil trading era. -
Uva-F-1274 Methods of Valuation for Mergers And
Graduate School of Business Administration UVA-F-1274 University of Virginia METHODS OF VALUATION FOR MERGERS AND ACQUISITIONS This note addresses the methods used to value companies in a merger and acquisitions (M&A) setting. It provides a detailed description of the discounted cash flow (DCF) approach and reviews other methods of valuation, such as book value, liquidation value, replacement cost, market value, trading multiples of peer firms, and comparable transaction multiples. Discounted Cash Flow Method Overview The discounted cash flow approach in an M&A setting attempts to determine the value of the company (or ‘enterprise’) by computing the present value of cash flows over the life of the company.1 Since a corporation is assumed to have infinite life, the analysis is broken into two parts: a forecast period and a terminal value. In the forecast period, explicit forecasts of free cash flow must be developed that incorporate the economic benefits and costs of the transaction. Ideally, the forecast period should equate with the interval in which the firm enjoys a competitive advantage (i.e., the circumstances where expected returns exceed required returns.) For most circumstances a forecast period of five or ten years is used. The value of the company derived from free cash flows arising after the forecast period is captured by a terminal value. Terminal value is estimated in the last year of the forecast period and capitalizes the present value of all future cash flows beyond the forecast period. The terminal region cash flows are projected under a steady state assumption that the firm enjoys no opportunities for abnormal growth or that expected returns equal required returns in this interval. -
Valuing the Employee Purchase of Employer Company Stock—Part II
VOL. 13, ISSUE NO. 4 OCTOBER 2010 Valuing the Employee Purchase of Employer Company Stock—Part II by Robert F. Reilly 8. Protective provisions and veto rights; 9. Board participation rights; Editor’s Note : The previous installment of this series sum- 10. Drag-along rights; marized the generally accepted valuation approaches related 11. Right to participate in future equity offerings; to the employee purchase of employer company stock. This 12. Right of fi rst refusal in future equity offerings; installment summarizes the impact of security-specifi c con- 13. Management rights; tractual rights and privileges on the employer stock valuation . 14. Access to information rights; and 15. Tag-along rights. Contractual Rights and Privileges Some contractual rights and privileges can separately (and Each of the above-listed contractual rights may relate to a materially) impact the stock value in an employee stock pur- particular class of employer company equity. More com- chase, as well as have an effect on the stock marketability and monly, these particular rights and privileges may only relate, control attributes. The valuation analyst should ensure that by contract, to a particular block of the company stock. For the value increment associated with contractual rights is not example, that block of stock may be the stock sold to the double-counted (i.e., both considered as a marketability/con- general employee group, the stock granted to identifi ed senior trol attribute and then added again as a contractual attribute). executives, or the stock retained by certain members of the company founding family. Each of these contractual rights and The analyst should also ensure that the full value increment privileges has a value. -
The Promise and Peril of Real Options
1 The Promise and Peril of Real Options Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 [email protected] 2 Abstract In recent years, practitioners and academics have made the argument that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. They have noted that these options need to be not only considered explicitly and valued, but also that the value of these options can be substantial. In fact, many investments and acquisitions that would not be justifiable otherwise will be value enhancing, if the options embedded in them are considered. In this paper, we examine the merits of this argument. While it is certainly true that there are options embedded in many actions, we consider the conditions that have to be met for these options to have value. We also develop a series of applied examples, where we attempt to value these options and consider the effect on investment, financing and valuation decisions. 3 In finance, the discounted cash flow model operates as the basic framework for most analysis. In investment analysis, for instance, the conventional view is that the net present value of a project is the measure of the value that it will add to the firm taking it. Thus, investing in a positive (negative) net present value project will increase (decrease) value. In capital structure decisions, a financing mix that minimizes the cost of capital, without impairing operating cash flows, increases firm value and is therefore viewed as the optimal mix. -
Empirical Testing of Real Option in the Real Estate Market
View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Elsevier - Publisher Connector Available online at www.sciencedirect.com ScienceDirect Procedia Economics and Finance 24 ( 2015 ) 50 – 59 International Conference on Applied Economics, ICOAE 2015, 2-4 July 2015, Kazan, Russia Empirical Testing of Real Option in the Real Estate Market Andrejs Čirjevskisa*, Ernests Tatevosjansb a RISEBA, Meza street 3, Riga LV 1048, Latvia, bRISEBA, Meza street 3, Riga LV 1048, Latvia Abstract Existing researches have used real options valuation (ROV) theory to study investment in energy, oil and gas, and pharmaceutical sectors, yet little works have empirically examined ROV theory to study investment in a real estate market of EU countries that undergone severe economic crisis and now recovering. The aim of this paper is to test empirically ROV application for real estate development project with significant volatility in terms of price and cost and under strict legislation’s constraints. Paper illustrates empirical testing of ROV application of the investment project “Sun Village” developed by the ABC Project Ltd Company in Latvia in 2014. We apply three ROV methods: option space matrix “Tomato Garden”, Black-Scholes option pricing model and binominal option pricing model before we presented final research result. The flow chart of ROV application in real estate development projects presented in our research can serve as a “road map” for many similar projects in EU suffering real estate market bubble burst and present uncertainty. © 2015 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license © 2015 The Authors.