Contingent Claim (Option) Valuation

 Options have several features

1.      They derive their value from an underlying asset, which has value

2.      The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.

3.      They have a fixed life

Any security that shares these features can be valued as an option.

 

Direct Examples of Options

1.      Listed options, which are options on traded assets, that are issued by, listed on and traded on an option exchange.

2.      Warrants, which are call options on traded stocks, that are issued by the company. The proceeds from the warrant issue go to the company, and the warrants are often traded on the market.

3.      Contingent Value Rights, which are put options on traded stocks, that are also issued by the firm. The proceeds from the CVR issue also go to the company

4.      Scores and LEAPs, are long term call options on traded stocks, which are traded on the exchanges.

 

Indirect Examples of Options

1.      Equity in a deeply troubled firm - a firm with negative earnings and high leverage - can be viewed as an option to liquidate that is held by the stockholders of the firm. Viewed as such, it is a call option on the assets of the firm.

2.      The reserves owned by natural resource firms  can be viewed as call options on the underlying resource, since the firm can decide whether and how much of the resource to extract from the reserve,

3.      The patent owned by a firm or an exclusive license  issued to a firm can be viewed as an option on the underlying product (project). The firm owns this option for the duration of the patent.

4.      The rights possessed by a firm to expand an existing investment into new markets or new products.

 

Advantages of Using Option Pricing Models

Option pricing models allow us to value assets that we otherwise would not be able to value. For instance, equity in deeply troubled firms and the stock of a small, bio-technology firm (with no revenues and profits) are difficult to value using discounted cash flow approaches or with multiples. They can be valued using option pricing.

Option pricing models provide us fresh insights into the drivers of value. In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it.

 

Disadvantages of Option Pricing Models

When real options (which includes the natural resource options and the product patents) are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task.

The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you first need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

Finally, there is the danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash flow valuation for a pharmaceutical firm because it has valuable patents would be double counting the patents if he values the patents as options and adds them on to his discounted cash flow value.