Question one

discuss how Faoilean Co may use the idea of options to help with the investment decision in bidding for
the exploration rights, and explain the assumptions made when using the idea of options in making
investment decisions

Applies only for European options

Assumes that the risk free rate of return is known and it will remain constant throughout the period

Assumes that no dividends are paid during the option period

Assumes that no transaction costs are involved in buying and selling of options

Standard deviation of the returns of the underlined security is constant

a. With conventional investment decisions, it is assumed that once

a decision is made, it has to be taken immediately and carried to
its conclusion.

These decisions are normally made through conventional

assessments using methods such as net present value.

Assessing projects through option pricing may aid the investment

decision making process.

Where there is uncertainty with regard to the investment decision and

where a company has flexibility in its decision making, valuing projects
using options can be particularly useful.

For example, situations may exist where a company does not have to
make a decision on a now-or-never basis, or where it can abandon a
decision, which has been made, at some future point, or where it has
an opportunity for further expansion as a result of the original decision.

In such situations, using option pricing formulae, which incorporate the

uncertainty surrounding a project and the time before a decision has
to be made, can determine a value attached to this flexibility.

This value can be added to the conventional net present value

computation to give a more accurate assessment of the project’s
value.
In the situation which Faoilean Co is considering, the initial exploration
rights may give it the opportunity to delay the decision
of whether to undertake the extraction of oil and gas to a later date.

In that time, using previous knowledge and experience, it can estimate

the quantity of oil and gas which is present more accurately.

It can also use its knowledge to assess the variability of the likely
quantity. Faoilean Co may be able to negotiate a longer time scale
with the government of Ireland for undertaking the initial exploration,
before it needs to make a final decision on whether and how much to
extract.

Furthermore, Faoilean Co can explore the possibilities of it exiting the

extraction project, once started, if it is proving not to be beneficial, or if
world prices of oil and gas have moved against it.

It could, for example, negotiate a get-out clause which gives

it the right to sell the project back to the government at a later date at
a pre-agreed price.

Alternatively, it could build facilities in such a way that it can redeploy

them to other activities, or scale the production up or down more
easily and at less cost.

These options give the company the opportunity to step out of a

project at a future date, if uncertainties today become negative
outcomes in the future.

Finally, Faoilean Co can explore whether or not applying for the rights
to undertake this exploration project could give it priority
in terms of future projects, perhaps due to the new knowledge or
technologies it builds during the current project.

These 22 opportunities would allow it to gain competitive advantage

over rivals, which, in turn, could provide it with greater opportunities in
the future, but which are uncertain at present.
Faoilean Co can incorporate these uncertainties and the time before
the various decisions need to be made into the option formulae to
determine the additional value of the project, on top of the initial net
present value calculation.

The option price formula used with investment decisions is based on

the Black-Scholes Option Pricing (BSOP) model. The BSOP model
makes a number of assumptions as follows:

– The underlying asset operates in perfect markets and therefore the

movement of market prices cannot be predicted;

– The BSOP model uses the risk-free rate of interest. It is assumed

that this is known and remains constant, which may the time it takes
for the option to expire may be long;

– The BSOP model assumes that volatility can be assessed and stays
constant throughout the life of the project; again with long-term
projects these assumptions may not be valid;

– The BSOP model assumes that the underlying asset can be traded
freely. This is probably not accurate where the underlying asset is an
investment project. These assumptions mean that the value based
around the BSOP model is indicative and not definitive.

Part B

Equity can be regarded as purchasing a call option by the equity

holders on the value of a company, because they will possess a
residual claim on the assets of the company.

In this case, the face value of debt is equivalent to the exercise price,
and the repayment term of debt as the time to expiry of the option.

If at expiry, the value of the company is greater than the face value of
debt, then the option is in-the-money, otherwise if the value of the firm
is less than the face value of debt, then the option is out-of-money and
equity is worthless.
For example, say V is the market value of the assets in a company, E
is the market value of equity, and F is the face value of debt, then,

If at expiry V > F (option is in-the-money), then the option has intrinsic

value to the equity holders and E = V – F;

Otherwise if F > V (option is out-of-money), then the option has no

intrinsic value and no value for the equity holders, and E = 0.

Prior to expiry of the debt, the call option (value to holders of equity)
will also have a time value attached to it.

The BSOP model can be used to assess the value of the option to the
equity holders, the value of equity, which can consist of both time
value and intrinsic value if the option is in-the-money, or just time
value if the option is out-of-money.

Within the BSOP model, N(d1), the delta value, shows how the value
of equity changes when the value of the company’s assets change.
N(d2) depicts the probability that the call option will be in-the-money
(i.e. have intrinsic value for the equity holders).

Debt can be regarded as the debt holders writing a put option on the
company’s assets, where the premium is the receipt of interest when it
falls due and the capital redemption.

If N(d2) depicts the probability that the call option is in-the-money,

then 1 – N(d2 ) depicts the probability of default.

Therefore the BSOP model and options are useful in determining the
value of equity and default risk.

Option pricing can be used to explain why companies facing severe

financial distress can still have positive equity values.

A company facing severe financial distress would presumably be one

where the equity holders’ call option is well out-of-money and
therefore has no intrinsic value.
However, as long as the debt on the option is not at expiry, then that
call option will still have a time value attached to it.

Therefore, the positive equity value reflects the time value of the
option, even where the option is out-of-money, and this will diminish
as the debt comes closer to expiry.

The time value indicates that even though the option is currently out-
of-money, there is a possibility that due to the volatility of asset values,
by the time the debt reaches maturity, the company will no longer face
financial distress and will be able to meet its debt obligations.
Part c

According to the BSOP model, the value of an option is dependent on

five variables: the value of the underlying asset, the exercise price, the
risk-free rate of interest, the implied volatility of the underlying asset,
and the time to expiry of the option. These five variables are input into
the BSOP formula, in order to compute the value of a call option (the
value of an equivalent put option can be computed by the BSOP
model and put-call parity relationship). The different risk factors
determine the impact on the option value of the changes in the five
variables.

The ‘vega’ determines the sensitivity of an option’s value to a change

in the implied volatility of the underlying asset. Implied
volatility is what the market is implying the volatility of the underlying
asset will be in the future, based on the price changes in an option.
The option price may change independently of whether or not the
underlying asset’s value changes, due to new information being
presented to the markets. Implied volatility is the result of this
independent movement in the option’s value, and this determines the
‘vega’. The ‘vega’ only impacts the time value of an option and as the
‘vega’ increases, so will the value of the option.
Question two
a. Government Change

From the facts of the case it would seem that a change of government could have a significant impact on
whether or not the project is beneficial to Tramont Co. The threat to raise taxes may not be too
significant as the tax rates would need to increase to more than 30% before Tramont Co would lose
money. However, the threat by the opposition party to review ‘commercial benefits’ may be more
significant.

Just over 40% of the present value comes from the tax shield and subsidy benefits. If these were
reneged then Tramont Co would lose a significant of the value attached to the project. Also the new
government may not allow remittances every year, as is assumed in part (i). However this may not be
significant since the largest present value amount comes from the final year of operation.

Other Business Factors

Tramont Co should consider the possibility of becoming established in Gamala, and this may lead to
follow-on projects. The real options linked to this should be included in the analysis.

Tramont Co’s overall corporate strategy should be considered. Does the project fit within this strategy?
Even if the decision is made to close the operation in the USA, there may be other alternatives and these
need to be assessed.

The amount of experience Tramont Co has in international ventures needs to be considered. For
example, will it be able to match its systems to the Gamalan culture? It will need to develop strategies to
deal with cultural differences. This may include additional costs such as training which may not have
been taken into account.

Tramont Co needs to consider if the project can be delayed at all. From part (i), it can be seen that a
large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the
commencement of the project may increase the overall value of the project.

Tramont Co needs to consider the impact on its reputation due to possible redundancies. Since the
production of X-IT is probably going to be stopped in any case, Tramont Co needs to communicate its
strategy to the employees and possibly other stakeholders clearly so as to retain its reputation. This may
make the need to consider alternatives even more important.

b) A triple bottom line (TBL) report provides a quantitative summary of performance in terms of
economic or financial impact, impact on the environment and impact on social performance. TBL
provides the measurement tool to assess a corporation’s or project’s performance against its objectives.
The principle of TBL reporting is that true performance should be measured in terms of a balance
between economic (profits), environmental (planet) and social (people) factors; with no one factor
growing at the expense of the others. The contention is that a corporation that accommodates the
pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as
long as the benefits that accrue from producing such a report exceeds the costs of producing it. For
example, in the case of the X-IT, reporting on the impact of moving the production to Gamala, in terms
of the impact on the employees and environment in the USA and in Gamala will highlight Tramont Co as
a good corporate citizen, and thereby increase its reputation and enable it to attract and retain high
performing, high calibre employees. It can also judge the impact on the other business factors
mentioned in the report above

(c) Shareholders holding well-diversified portfolios will have diversified away unsystematic or company
specific risk, and will only face systematic risk, ie risk that can not be diversified away. Therefore a
company can not reduce risk further by undertaking diversification within the same system or market.
However, further risk reduction may occur if the diversification is undertaken by the company, on behalf
of the shareholders, into a system or market where they themselves do not invest. Some studies
indicate that even shareholders holding well-diversified portfolios may benefit from risk diversification
where companies invest in emerging markets. 17 In the case of Tramont Co and the X-IT, it is not clear
whether diversification benefits will result in the investment in Gamala. The benefits are dependent on
the size of the investment, and on the nature of the business operations undertaken in Gamala by
Tramont Co. And whether these operations mirror an investment in a significantly different system or
market. If the investment is large, the operations are similar to undertaking a a Gamalan company.
Tramont Co’s shareholders who do not hold similar companies’ shares in their portfolios may then gain
risk diversification benefits from the Gamalan investment.

Question 3

Using a hypothetical example of your own choosing, demonstrate that the options value (whether call
option or put option) varies directly with the variance of the value of the underlying asset. (10 Marks)

Question

Sharpe index is superior to Treynor’s index in assessing portfolio performance. Assess the boundaries
within which this assertion may be valid if at all.

Limitations of Each Ratio

There are certain drawbacks to each of these ratios. Where the Sharpe ratio fails
is that it is accentuated by investments that don't have a normal distribution of
returns like hedge funds.2

 Many of them use dynamic trading strategies and options that can skew their returns.
The main disadvantage of the Treynor ratio is that it is backward-looking and that
it relies on using a specific benchmark to measure beta. Most investments,
though, don't necessarily perform the same way in the future that they did in the
past.

The Bottom Line

The difference between the two metrics is that the Treynor ratio utilizes beta, or
market risk, to measure volatility instead of using total risk (standard deviation)
like the Sharpe ratio.

The Sharpe ratio helps investors understand an investment's return compared to

its risk while the Treynor ratio explores the excess return generated for each unit
of risk in a portfolio.
Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on
the basis of both the rate of return and diversification (it considers total portfolio
risk as measured by the standard deviation in its denominator). Therefore, the
Sharpe ratio is more appropriate for well-diversified portfolios because it more
accurately takes into account the risks of the portfolio.

Other relevant questions

1a. Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest
rate collar instead of options

The main advantage of using a collar instead of options to hedge interest rate risk is lower cost. A collar
involves the simultaneous purchase and sale of both call and put options at different exercise prices. The
option purchased has a higher premium when compared to the premium of the option sold, but the
lower premium income will reduce the higher premium payable. With a normal uncovered option, the
full premium is payable.

However the disadvantage of this is that, whereas with a hedge using options the buyer can get full
benefit of any upside movement in the price of the underlying asset, with a collar hedge the benefit of
the upside movement is limited or capped as well.

b. b) Based on the three hedging choices Alecto Co is considering and assuming that the company
does not face any basis risk, recommend a hedging strategy for the €22,000,000 loan. Support
the recommendation with appropriate comments and relevant calculations in €.17mks
c. (c) Explain what is meant by basis risk and how it would affect the recommendation made in
part (b) above. (4 marks)

d. Calculate the required return for federal express assuming it has a beta of 1.25, the rate on US
T-bills is 5% and the expected return for the S&P 500 is 15%.

E(Ra)= 5%+1.25 (15%-5%)=17.5%

Whats the difference between SML (security market line or capital asset pricing) and
CML(capital market line)

SML
Measures market risk through beta. Hence beta is on the x axis and expected return on y axis.
Concerned with specific security
The measure of the risk free measure to the market is zero. There is no risk associated with the
risk free investment.
A market portfolio has a beta of 1.
Expected return=

CML
Standard deviation on the x axis and expected return on y-axis. Means reporting returns against
standard deviation.
Concerned with actual efficient portfolios. Represents portfolios that include the risk free asset