AFM – Application of option pricing

theory in investment decisions

Contents
Introduction to Options ......................................................................................................... 3
DEFINITION: ........................................................................................................................ 3
CATEGORIES: ....................................................................................................................... 3
EXERCISING AN OPTION: .................................................................................................... 4
INTRINSIC VALUE OF THE OPTION: ..................................................................................... 4
TIME VALUE OF AN OPTION: .............................................................................................. 4
Option Value Sensitivity ......................................................................................................... 6
CORE VARIABLES THAT IMPACT OPTION VALUES .............................................................. 6
The Black and Scholes formula .............................................................................................. 8
BASIC VERSION OF THE BLACK AND SCHOLES FORMULA .................................................. 8
Example of Option Valuation Using the Black-Scholes Model............................................. 13
CALL OPTION:.................................................................................................................... 13
PUT OPTION: ..................................................................................................................... 15
Black and Scholes Option Pricing Model .............................................................................. 16
DEFINITION: ...................................................................................................................... 16
BLACK AND SCHOLES OPTION PRICING MODEL: .............................................................. 16
Option “Greeks” ................................................................................................................... 19
INTRODUCTION ................................................................................................................ 19
DELTA ................................................................................................................................ 19
GAMMA ............................................................................................................................ 20
VEGA ................................................................................................................................. 20
RHO ................................................................................................................................... 20
THETA................................................................................................................................ 20
Real Options ......................................................................................................................... 22
HYPOTHETICAL EXAMPLE ..................................................................................................... 22
CATEGORIES OF REAL OPTIONS ........................................................................................ 23
Valuation of real options ...................................................................................................... 24

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 INTRODUCTION ................................................................................................................ 24
BLACK AND SCHOLES MODEL ........................................................................................... 24
CURRENT PRICE AND EXERCISE PRICE .............................................................................. 24
VOLATILITY ........................................................................................................................ 25
TIME TO EXPIRY AND THE RISK-FREE INTEREST RATE ...................................................... 25
VALUATION EXAMPLE ...................................................................................................... 26
March/June 2018 – Sample Questions ................................................................................ 27

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Introduction to Options
DEFINITION:

An option gives its holder a right, but not an obligation, to buy or sell a particular asset,
referred to as the underlying asset, at a predetermined price, referred to as the exercise or
strike-price, on, or before, an agreed date.

There is asymmetry in the relationship between the holder and seller of an option, and the
holder has to pay a price for their contractual right to exercise the option. Under options
terminology, this price is referred to as the option premium.

CATEGORIES:

1. Call and Put Options:

Where the holder of the option has right to purchase the underlying asset is called Call
Option, whereas, the

option where the holder has the right to sell the underlying asset is called Put Option.

2. Vanilla and Exotic Options:

Vanilla Options:

i) European-style Options - Can only be exercised on the expiry date.

ii) American-style Options - Can be exercised by their holder on any day

between the inception of the contract and the expiry date.

Exotic Options:

i) Binary options - The holder’s payoff is a fixed amount.

ii) Barrier options - The option is switched on or off.

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3. Based on Underlying Assets:

i) Currency options

ii) Interest rate options

iii) Commodity options

iv) Equity options

4. Exchange and Over-the-Counted Traded:

Options can either be traded on organised exchanges or may be entered into on a bilateral
basis in the so-called “over-the-counter” market. The main difference between the two
types is that exchange-traded options are highly standardised, whereas the specific terms of
options concluded bilaterally are subject to negotiation between the parties.

EXERCISING AN OPTION:

The decision of exercising an option depends on the so-called intrinsic value of the option
on the settlement date, which is the difference between the market price of the underlying
and the exercise price (i.e. the option is in-the-money).

A call option is in-the-money when the market price of the underlying asset is higher than
the strike price, and out-of-the-money when it is lower.

A put option is in-the-money when the market price is lower than the strike and is out-of-
the-money when the market price is higher than the strike.

INTRINSIC VALUE OF THE OPTION:

Intrinsic value is a driver of the option price. Generally, the more an option is in-the-money,
the higher its price becomes. Conversely, when an option turns out-of-the-money, its price
becomes lower.

TIME VALUE OF AN OPTION:

The time value of an option represents the probability or likelihood that by the expiry date,
the market price of the underlying asset will change in such a way, that the option becomes
in-the-money and will be exercised. A deeply out-of-the-money option price is of low value,
however, its price never falls to zero as long as there is still time left until its expiry

The time value of an option decreases as the option ages, and on the expiry date, the entire
option value is made up solely of its intrinsic value. On the expiry date, the difference
between the strike and the market price is already fixed and can’t change anymore. Thus, it
is also known with certainty if the holder will exercise the option or not. Therefore, on the
expiry date, the value of an option is equal to its settlement amount, which is either the

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difference between the strike and the market price, when the option is in the money, or
zero, if the option is out of the money and expires unexercised.

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Option Value Sensitivity
CORE VARIABLES THAT IMPACT OPTION VALUES

The Black-Scholes Model states that there are five variables that impact the value of
options, let’s take an example of a simple European-style call option to understand how
each variable impacts the value of this option. This option to buy stock/share in a company
is currently trading at €140. Assume that the option is exercisable in exactly 1 month’s time.

1. Exercise price:

If the exercise price of the above-mentioned call options is €145, we can certainly not
exercise it today (market price < exercise price), as the option is out-of-the-money by €5.
What if the exercise price is lowered to €135, the option turns in-the-money. Here we have
witnessed how a change in exercise price can impact the price of a call option. This relation
can be expressed as:

Negative (or inverse) relation between the exercise price and value of call option.

2. Current value of the underlying asset:

If the current market value of the underlying asset changes to €143, instead of €140, the
difference between the exercise price and current value of the underlying asset reduces to
only €3, instead of €5, as in the case above. The current value of the share only needs to
increase by €2 to turn in-the-money. Here we have witnessed how a change in the current
market value of the underlying asset can impact the price of a call option. This relation can
be expressed as:

Positive relation between the current value of underlying asset and value of call option.

3. Volatility of the underlying asset:

If these shares show a volatility of 5% per month, as the current value of the shares is €140
per share, 5% of

the current value if €7. There is a 50% probability that the value of the shares will increase
to (€140 + €7 =)

€147 / share, or 50% probability that the value of the shares will decreases to (€140 – €7 =)
€133. Increase in the share price to €147 will lead to gain of €2 (option will be exercised),
however, if the value of the shares decrease to €133 / share, the option will not be
exercised leading to no gain or loss. Taking the probabilities of each possibility, the expected
value of the gain would be: (€2 x 0.5) + (€0 x 0.5) = €1.

Now let’s assume that the volatility of the underlying asset it 10%. If the probabilities of
upward and downward movement remain the same, a fluctuation of 10% of €140 means a

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change of €17 / month. This would increase the gain from an increase in the value of the
shares to €9, whereas, the negative movement will again result in no gain or loss. Here the
expected value of the gain would be: (€9 x 0.5) + (€0 x 0.5) = €4.5.

Here we witnessed how the volatility of the underlying asset can impact the price of a call
option. This relation can be expressed as:

Positive relation between the volatility of underlying asset and value of call option.

4. Time to maturity of option:

Taking the example, where the volatility of the shares was assumed 5% per month, ahead.
What if we gave the option more time (two months instead of just one), this way, the
underlying asset would have more of a chance to change either up or down by a larger
amount. As we have already seen, that the potential for larger swings in the underlying
asset has a positive impact on options, so more time left until option expiry means higher
call option values. This relation can be expressed as:

Positive relation between time to maturity of the call option and value of the call option.

5. Interest rate:

Finally, as the potential outflow from exercising the option will occur in 1 month’s time, the
future cash flow ought to be evaluated from the perspective of its present value. The cash
flow will be discounted using the interest rate, if the interest rate is high, the present value
of the outflow will be low, and therefore, the value of the call option will increase. This
relation can be expressed as:

Positive relation between interest rate and value of call option.

SUMMARY

Sr. No. Variable Relation with value of call option

1 Exercise price Inverse/negative
2 Current value of underlying asset Positive
3 Volatility of underlying asset Positive
4 Time to maturity Positive
5 Interest rate Positive

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The Black and Scholes formula
BASIC VERSION OF THE BLACK AND SCHOLES FORMULA

The Black and Scholes model was originally designed for the valuation of European-style call
options on non-dividend paying equity shares. Since then the model has been modified and
there are currently many extension of it, which allows for the valuation of other option
types, including options on dividend paying shares and currencies. There are also formulas
enabling the valuation of binary options.

Note: There are types of options, which simply cannot be valued using the Black and Scholes
model. These are in particular American-style put options and sophisticated exotic options,
for example, those with multiple barriers. For such options, lattice models, based on an
analysis of binomial trees or simulations, must be used.

The basic and most accessible version of the Black and Scholes formula expresses the value
of a European-style call option on a non-dividend paying share:

Where:

Pa – current price of underlying;

Pe – exercise (strike) price;

e-rt – discount factor (continuous compounding).

Note: The equation makes use of continuous compounding, by utilising the mathematical “e”
constant, referred to as “Euler’s number”. The “e” constant is a unique number, used as the
base of the natural logarithm, and equals approximately 2.71828. In continuous
compounding, “e” raised to the power of minus the interest rate multiplied by time becomes
the discount factor representing time “t” and the interest rate “r”.

It may be said that the N(d2) factor represents the risk-adjusted probability that the option
will be exercised.

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Accordingly, the second component of the Black and Scholes formula may be interpreted as
the discounted, probability weighted pay-out from the option.

N(d1) is the factor, by which the present value of the receipt of the share, which is
contingent on the exercise of the option, is higher than the current value of that share. To
put it in other words, N(d1) is the so-called hedge ratio, or the number of shares that should
be invested in, to counterbalance the future pay-out from exercising the option. This hedge
ratio is also referred to as the option “delta”, and we will learn more about it further on in
this module.

The N(d1) and N(d2) factors represent outcomes from the cumulative standard distribution
function, calculated for the input values d1 and d2, respectively. Accordingly, N(d1) and
N(d2) are equal to areas under the standard normal distribution curve. Because of its
characteristic shape, the curve is sometimes referred to as the “bell curve”:

As you can see, the further away we move from the mean value, the lower the function
becomes. Because the distribution is symmetrical, the absolute change in probability density
is the same irrespective of whether we move left or right of the mean by the same distance.

The area between the curve and the horizontal axis depicts the cumulative probability of
occurrence of a given event. The entire field below the curve amounts to one, so it
represents the entire probability of occurrence of any event in the data set. In a standard
normal distribution, the probability amounts to 50% for an input value of zero, 15.87% for
an input equal to -1 and 84.13% for an input of plus 1.

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The probability associated with a given input value may be found in the normal distribution
table using the following rules:

– You have to round the input number to two decimal places;

– You need to locate the first decimal digit in the first column of the table, and the second
digit in the first row;

– The required outcome is found at the intersection of the relevant row and column;

– To obtain the probability amount you have to deduct the outcome found in the table
from 0.5, if the input was negative, or add the outcome to 0.5, if the input was positive.

Example:

If we are looking for the standard normal probability of -1.21, we need to find the
intersection of row 1.2 and column 0.01. The outcome is 0.3869:

Standard normal probability = -121

Standard normal distribution table
0.00 0.01 0.02 0.03 0.04 0.05
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531
1.1 0.3634 0.3665 0.3668 0.3708 0.3729 0.3749
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265

Cumulative probability of -1.21 = 0.5 - 0.3869 = 0.1131 = 11.31%

Cumulative probability of 1.21 = 0.5 + 0.3869 = 0.8869 = 88.69%

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The input values d1 and d2 are calculated as follows:

In the Black and Scholes formula, volatility is expressed as the annual standard deviation of
returns of the underlying asset, which is also equal to the square root of the variance of
those returns.

Remember: Because the Black and Scholes formula uses annual volatilities if the volatility
for a given underlying is quoted on a monthly or weekly basis, it has to be annualised. To do
that, the volatility first has to be squared and then, scaled to an annual basis. The last step
includes taking the square root of the result.

EXAMPLE:

Weekly volatility 5%
Square weekly volatility 5% x 5% = 0.25%
Multiply by 52 (number of weeks) 0.25% x 52 = 13%
Square root of result 13%1/2 = 36.1%

Although the Black and Scholes formula was designed to compute the value of a European
call option, the model may also be used to calculate the value of a put option. For that
purpose, we need to use a formula referred to as put-call parity, which depicts the
relationship between the value of a call and put option with otherwise identical parameters:

MODIFICATIONS OF THE ORIGINAL BLACK AND SCHOLES MODEL

There are certain modifications of the original Black and Scholes model exist, allowing for
the valuation of other option types than just European options on shares that do not pay
dividends.

The simplest of these modifications is the one enabling the valuation of a European-style
option on a stock, which will pay a dividend before the option matures. In order to calculate
the value of such an option, the original Black and Scholes formula may be used, but the
current share price has to be adjusted for the present value of future dividends, which will
be paid out before the option expires.

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Another frequently used modification of the model is the so-called Grabbe variant, allowing
for the valuation of currency options. The main difference between this variant and the
original formula is the incorporation of two interest rates for the currencies whose exchange
rate constitutes the option underlying.

LIMITATIONS OF THE FORMULA

It is essential to also note the limitations of the Black and Scholes formula:

 The model was designed for the calculation of values of European-style options on
shares, which do not pay dividends;

 There are still certain types of options, which cannot be valued under the model. These
are in particular American-style puts and many exotic options.

ASSUMPTIONS

– The model assumes that there are no taxes and no transaction costs;

– It is assumed that investors are able to borrow funds at the risk-free rate, and that
interest is calculated using continuous compounding;

– The model assumes that the underlying asset generates returns, which follow the
normal distribution, which does not hold true for certain types of assets;

 The formula uses the volatility of the underlying asset as a crucial input. However,
volatility is a prospective measure and in order to allow for the proper valuation of
options, the so-called implied or market volatility should be plugged into the model,
instead of historical values.

- Implied volatility is not directly observable in the market, but is in fact derived from
market prices of options, quoted by market makers;

- Implied volatility is subject to a phenomenon referred to as the volatility smile,

which means that options on the same underlying asset may feature different
volatilities depending on the strike price.

Nevertheless, the Black and Scholes formula remains the main tool which is globally used
not only for the valuation of financial options but also in other areas of finance.

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Example of Option Valuation Using the Black-Scholes Model
CALL OPTION:

We will be calculating the value of a European-style call option for a share of a company,
whose current price is €200. The strike price of the option is €220, so the option is out of the
money, with an intrinsic value of zero. Let us further assume that the risk-free interest rate
is 5% per annum and that the annual volatility of the share price amounts to 30%. The time
left until expiry of the call is 6 months or half a year.

The Black-Scholes formula is:

Let’s start by computing the d1 factor:

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Having computed the d1 factor, we can now move on to the computation of d2. As you may
recall, its formula is much shorter than in the case of d1, d2 is simply:

Now that we know the values of the d1 and d2 factors, we may proceed with finding the
relevant probabilities from the normal distribution function. First, let’s round d1 and d2 to 2
decimal places, so as to be able to use the normal distribution table:

Round d1 and d2 to two decimal places: d1 = –0.23 | d2 = –0.44

To find the relevant cumulative probability for d1, we have to locate the number at the
intersection of the row labelled 0.2 with the column labelled 0.03. As d1 is negative, finding
the relevant probability requires subtracting the result from 0.5. Similarly, d2 equals –0.44
we will find the relevant number at the intersection of row 0.4 and column 0.04, and will
subsequently have to subtract it from 0.5.The cumulative probability N(d1) and N(d2) are:

Standard normal distribution table

0.00 0.01 0.02 0.03 0.04 0.05
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736

d1 = 0.5 – 0.0910 = 0.41

d2 = 0.5 – 0.17 = 0.33

The final step in calculating the value of the call option is plugging the computed
probabilities into the formula:

Knowing that the intrinsic value of the option is zero, we may conclude that the entire
option value is in fact accounted for by time value.

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PUT OPTION:

Now that we know the value of the call option, we can make use of put-call parity to
calculate the value of a put option with identical parameters that is an option to sell an
identical share at €220 in 6 months’ time.

Under the parity, the value of a put equals the value of a call less the current price of the
share, plus the strike price discounted over the time left to expiry using the risk-free rate:

Put = Call  Pa + Peert

Put = 11.22  200 + 220 × 0.975

Put = €25.72

NOTE: This model may also be used to find the value of American-style calls, but not
American-style puts. In fact, it can be proven that an American-style call option has the same
value as a European-style call with the same parameters that is with the same underlying,
exercise price and time left to expiry. The mathematical derivation of that proof is, however,
beyond the scope of this course.

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Black and Scholes Option Pricing Model
DEFINITION:

An option is a right, but not an obligation to buy or sell an asset at a future date at a price
agreed now. There are mainly three types of options:

1) European options. They may only be exercised on the date of expiration;

2) American options. They may be exercised on any trading day on or before

expiry;

3) Bermudan options. They may be exercised only on specified dates on or before

expiry.

Note: Here we will use only European options.

BLACK AND SCHOLES OPTION PRICING MODEL:

We will use Black and Scholes option pricing model to value both a Call option and a Put
option:

- A Call option is an option to buy something, e.g., an asset, at a price agreed now, but
we are not under any obligation to buy the asset;

- A Put option is an option to sell at a price agreed now, but still with no obligation.

There are five key variables in the formula:

1) r - Risk free rate of interest (given as a percentage). When we buy an option on

the share, we postpone buying the actual share. If we did buy the share, we
would either borrow the money or take money from deposit. Therefore, by
buying the option, we save interest on the borrowing. The higher the interest
rate, the greater the saving and, therefore, the higher the value of the option;

2) t - Time to expiry of the option (in years). The longer the time to expiry of the
option, the greater the change that the price of the share would rise and,
therefore, the more valuable the option;

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 3) Pa - Current price of the share.

4) Pe - Exercise price of the option (strike price);

5) s - Standard deviation or volatility (given as a percentage). The more volatile the price
of the share, the more valuable is the Call option on that share.

Formula for a Call option looks as follows:

Let's look at the model in its simplest form:

d1 in the formula for a Call option is calculated as follows:

d2 is calculated as follows:

N is calculated by taking the figures calculated for d1 and d2, going to the normal
distribution table, and locating the correct figure. Remember, if di is greater than zero, add
0.5 to the relevant number from the table. If di is less than zero, subtract the relevant
number from 0.5.

e is the exponential (you need to press “2nd F” and “ln” on your calculator), which is the
figure 2.718.

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Formula for a Put option (when a value of the Call option is known) is called a Put Call Parity
formula. It describes the relationship between the price of a European Call option and a
European Put option when both the strike price and expiry are identical. The formula looks
as follows:

p = c – Pa + Pee-rt
Note: The formula can also be used to arrive at the value of a Call option when the value of
the Put option is given.

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Option “Greeks”
INTRODUCTION

Option “greeks” measure the sensitivity of an option’s value to a small change in a specific
risk parameter. Greeks are crucial for effective management of a portfolio of options, as
they allow for the hedging of a portfolio against specific risks. We will describe the following
risk measures:

 Delta;
 Gamma;
 Vega;
 Rho;
 Theta.

DELTA

The N(d1) parameter used in the Black and Scholes formula represents the Delta of the
option. In fact, Delta is a measure of the sensitivity of the option price to changes in the
value of the underlying asset. It also represents the so-called Delta hedge ratio, or the
amount of the underlying asset, which should be invested in by the option holder in order to
hedge against changes in the option value caused by a change in the price of the underlying
asset.

Delta hedging is commonly used by entities, which write options that are held by other
companies (e.g., banks).

Please note that the relationship between the price of the underlying asset and option value
is not linear. Accordingly, Delta, like any other sensitivity measure, only provides an
approximation of the change in option value caused by a relatively small change in the price
of the underlying. In fact, an option’s Delta changes when the parameters used in its
calculation fluctuate. These parameters are not only the price of the underlying asset but
also volatility and the level of interest rates.

The decay in time left until option expiry also has an impact on Delta. As we get closer to the
expiration of an option, its Delta approaches one of two possible values: either 0 or 1. This is
because on the expiration date, the option will either be exercised, meaning that the Delta
hedge ratio will equal 100% or will be left unexercised, and the Delta hedge ratio will be
zero.

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GAMMA

Gamma is the measure of the sensitivity of Delta to changes in the price of the underlying
asset. The higher the Gamma, the more volatile the Delta of the option, and hence the more
difficult it is to actually manage the risk associated with it.

VEGA

Vega is a measure which shows the relationship between option value and volatility of the
underlying asset. Alternatively, Vega is sometimes also referred to as kappa.

Vega is a positive number, implying that an increase in volatility will always lead to a growth
in option value. Typically, longer options have higher Vegas compared to shorter ones.

RHO

Rho describes an option’s sensitivity to changes in a risk-free interest rate. The more stable
the economy, the less relevant Rho becomes to the effective management of option
portfolios because interest rates typically do not fluctuate significantly and their impact on
option values is not significant as well.

There are, however, option types, where interest rate volatility has a critical impact on their
values. These are:

a) Interest rate options, where the interest rate itself constitutes the underlying asset;

b) Currency options, where the differential between interest rates in the domestic
currency and the foreign currency will have a significant impact on the financing of the
position in the underlying.

Note: There are two separate Greeks which measure their sensitivity to changes in interest
rates: Rho for the interest rate in the domestic currency, and Phi for the interest rate in the
foreign currency.

Rho is a positive number for call options and a negative number for put options.
Accordingly, in the case of put options, an increase in interest rates leads to a decline in
option value.

THETA

Theta describes the change in option value over time. As you know, the value of an option
comprises two components:

- Intrinsic value, and

- Time value.

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As we get closer to an option’s expiration date, the more its intrinsic value approaches
either:

 The difference between the strike and the current market price of the underlying - if
the option will be exercised, or
 Zero - if the option will expire unexercised.

Time value, on the other hand, is always equal to zero on the expiration date. So, the value
of the option decays as it approaches maturity, and Theta is a measure of this decay.
Therefore, Theta is always a negative number.

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Real Options
A real option represents a choice that a company has in pursuing its investment policy.
Accordingly, a real option is not a financial derivative, but rather an actual business
opportunity that a company may deploy, which may be assessed using the options valuation
framework.

There are certain analogies between financial options and real options. Similarly to financial
options, a real option represents a right, but not an obligation, to undertake a certain
business activity. What is more, securing access to a business opportunity treated as a real
option, typically requires an initial investment, which is analogous to the premium that is
paid when a financial option is purchased.

The real options approach allows for the valuation of flexibility when tackling economic and
market changes.

HYPOTHETICAL EXAMPLE
Let’s assume a company is planning to build a new production plant. The initial plan
assumes that the company will use the plant to produce components needed for one of its
products, which were previously purchased from a supplier.

The traditional evaluation approach would be based on assessing future cash flows
generated through savings achieved by producing the components internally and
discounting them with a rate reflecting the cost of capital needed to finance the investment.

Under the real options approach, the cost associated with building a new manufacturing
facility is just a price which gets paid for a whole portfolio of options, that the company may
realise in the future, and the internal production of components is only one of the options.
The company may utilise the new plant in following ways:

 To introduce a new product to the market;

 To increase production of another product or component;

 To sell off the production plant.

All of these possibilities represent real options, which may, potentially, be exercised,
depending on future conditions. Real options theory suggests that all such options should
be valued in order to appropriately appraise the investment project.

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CATEGORIES OF REAL OPTIONS

1. Option to delay/defer (American-style call option)

A company will hold such an option when it has exclusive rights to a given project or
product, which may be deployed at a future point in time.

For example, a company may have patent rights allowing it to produce an innovative
product. The current NPV of bringing that product to the market is negative, however, it is
possible that in the future the factors that make the project unprofitable right now, will be
removed.

2. Option to switch/redeploy (Put option)

This applies to the way in which a company utilises its assets.

Imagine a company using its plant to produce product X. Alternatively the plant may also be
used to produce product Y, however product X is more profitable. Switching to the
production of Y remains a real option held by the company, and will be exercised when the
present value of the benefits of switching production exceed the costs associated with
making that switch.

3. Option to expand (Call option)

A company has an option to expand when an investment project is pursued in such a way
that some extra, unused capacity is created.

For example, a company increases the spare production capacity, this also increases the
overall cost of the project, nevertheless, it provides for greater flexibility. Under the real
options approach, this additional cost represents the price paid for the option to expand,
which the company should exercise when market demand for its products exceeds current
capacity levels.

4. Option to abandon (American-style put option)

This is typically associated with investment processes realised in stages.

A simple example is where an investor, after the completion of one of the stages of
investment, decides whether to continue the process or close the project.

SUMMARY

 Neither real options nor their underlying assets are traded.

 The underlying assets which are found in real options are not always easily
identifiable.

 The valuation of real options is relatively difficult.

23
Valuation of real options
INTRODUCTION

Despite clear analogies between real options and financial options, notable differences
between them exist. These differences relate, among others, to the interpretation of
valuation parameters, such as volatility, which, in the case of real options is thought of as
the level of uncertainty with regard to the future evolution of the parameters that
determine the value of the project, analysed jointly with the ability to respond to the
evolution of these parameters.

As a result, the valuation of real options is more difficult than in the case of financial options
and may be a complex and challenging task.

BLACK AND SCHOLES MODEL

Here we will only focus on those types of real options, which may be valued using the Black
and Scholes model.

Successful application of the formula to real options requires identification of the underlying
asset and appropriate interpretation of the model’s inputs, such as:

 Current price;
 Exercise price;
 Volatility;
 Time to expiry;
 Risk-free interest rate.

 Generally, the Black and Scholes model may be applied only to those types of real
options, which are exposed to just a single source of volatility, and have a single
decision date;

 Consequently, the real options which may effectively be valued under the model are
European-style call and put options as well as American-style call options, which, have
the same value as European calls sharing the same parameters. These are options to
delay and to expand, representing call options, and options to abandon realised in one
stage, representing put options.

CURRENT PRICE AND EXERCISE PRICE

In the case of simple real options, the underlying asset is typically the investment project
that is being considered by the company, whose value is measured by the NPV of its future
cash flows. The present value of future cash flows represents the current price of the

24
underlying asset. It is important to mention that the amount of initial investment should be
excluded from the NPV computation.

The required capital investment can usually be plugged into the Black and Scholes model as
the strike price. In the case of put options, such as an option to abandon, the strike price is
the salvage value of the abandoned investment.

Having discussed the price of the underlying and the strike price, we may define the criteria
under which real options are actually exercised:

 A call option is exercised when, on the expiry date, the strike price is lower than the
price of the underlying;
 An option to delay or to expand will be exercised if the required investment is lower
than the NPV of future cash inflows;
 A put option, on the other hand, is exercised if, on the expiry date, the strike price is
higher than the price of the underlying;
 An option to abandon will be exercised when the liquidation value of a project
becomes higher than the present value of the cash flows expected to have been
generated from it.

VOLATILITY

With the underlying asset being the present value of future cash flows, volatility is a
measure encompassing all of the risk factors with direct or indirect impact on those cash
flows. Please note that not all risk factors can be identified and accurately quantified,
therefore deriving the volatility parameter is generally a tricky task.

The most frequent practices in this respect are applying the Monte-Carlo method to
simulate a range of potential outcomes or using the volatility of proxy securities, which
share the same risk characteristics as the underlying investment project.

TIME TO EXPIRY AND THE RISK-FREE INTEREST RATE

Establishing the time to expiry is rather straightforward in the case of real options pertaining
to a single investment.

With respect to the interest rate factor, the use of the risk-free interest rate as a discount
rate in the valuation of real options is questioned by some authors, who claim that a risk-
adjusted interest rate is more appropriate. Since the debate in this area has not been
settled, we will stick with the risk-free rate.

25
VALUATION EXAMPLE

Question:

Imagine a German company considering entry onto the Spanish market. Since both
countries belong to the Eurozone, there are no foreign exchange issues associated with the
investment. The company is planning to invest 300 million euro in the first phase of the
expansion, with the present value of projected future cash inflows amounting to 250 million
euro. The NPV of the project is thus negative and comes in at minus 50 million euro.

The company would normally reject the project, but undertaking the investment creates the
potential for a future expansion option. Management expect that five years from the initial
investment, the company will be able to invest a further 600 million euro in the Spanish
market. Evaluation of the expansion using the discounted cashflow method reveals, that
projected cash inflows have a present value of 450 million euro.

Solution:

As it can be seen, the net value of the expansion project is also negative and at first
impression, it should not be considered. However, the expansion is a real option and can be
valued using the Black and Scholes formula. Let’s now calculate its value to see if this would
change our preliminary intuitive perception of the project.

As you know, an option to expand is a call option, and in this example, we will assume that it
is a European-style one.

To value the option, let’s first define the parameters:

Future investment Pe = 600

PV of inflows Pa = 450

Time to expiry t = 5 years

Volatility s = 30% p.a.

Risk-free rate r = 5% p.a.

26
In order to value the option under the Black and Scholes model, we have to first calculate
the probability factors N(d1) and N(d2). Let’s start by computing d1:

The next step in the valuation is finding the probability factors for the d1 and d2 values.
Using the normal distribution table we find the result 0.1103 corresponding to the input of
0.28, and the value 0.1517, which corresponds to the input of 0.39. D1 is higher than zero,
so we need to add 0.5 to the value found in the table. d2 is negative, so the N(d2) factor
equals the value found in the table subtracted from 0.5 Accordingly, the values of the N(d1)
and N(d2) factors are calculated as follows:

N(d1) = 0.1103 + 0.5 = 0.6103

N(d2) = 0.5 - 0.1517 = 0.3483

The last step of the valuation includes plugging the probability factors and other parameters
into the Black and Scholes formula, to obtain the value of the option:

Call option price = 450 * (0.6103) - 600 * (0.3483)*e-5%(5) = €111.63m

As you can see, at a volatility of 30% annually, the option to expand has a highly positive
value of above 111 million euro. To acquire this option, the company must invest in the first
stage of the project, which has an NPV of minus 50 million euro. Adding the two figures, we
receive a positive amount of almost 62 million euro, which suggests that the entire two-
stage project, including the initial stage and the option to expand, ought to be accepted.

27
 Professional Level – Options Module

P4 ACCA
Advanced Financial

Paper P4
Management
March/June 2018 – Sample
Questions

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

The Association of
Section A – This ONE question is compulsory and
Chartered Certified
MUST be attempted Section B – TWO questions ONLY
Accountants
to be attempted

Formulae and tables are on pages 10–14.

Do NOT open this question paper until instructed by

the supervisor.

This question paper must not be removed from the

examination hall.

28
Section A – This question is compulsory and MUST be attempted

1 Chikepe Co is a large listed company operating in the pharmaceutical industry with a

current market value of equity

of $12,600 million and a debt to equity ratio of 30:70, in market value terms. Institutional
investors hold most of its equity shares. The company develops and manufactures
antibiotics and anti-viral medicines. Both the company and its products have an established
positive reputation among the medical profession, and its products are used widely.
However, its rate of innovation has slowed considerably in the last few years and it has
fewer new medical products coming into the market.

At a recent meeting of the board of directors (BoD), it was decided that the company
needed to change its current strategy of growing organically to one of acquiring companies,
in order to maintain the growth in its share price in the future. The members of the BoD had
different opinions on the type of acquisition strategy to pursue.

Director A was of the opinion that Chikepe Co should follow a strategy of acquiring
companies in different business sectors. She suggested that focusing on just the
pharmaceutical sector was too risky and acquiring companies in different business sectors
will reduce this risk.

Director B was of the opinion that Director A’s suggestion would not result in a reduction in
risk for shareholders. In fact, he suggested that this would result in agency related issues
with Chikepe Co’s shareholders reacting negatively and as a result, the company’s share
price would fall. Instead, Director B suggested that Chikepe Co should focus on its current
business and acquire other established pharmaceutical companies. In this way, the company
will gain synergy benefits and thereby increase value for its shareholders.

Director C agreed with Director B, but suggested that Chikepe Co should consider relatively
new pharmaceutical companies, as well as established businesses. In her opinion, newer
companies might be involved in research and development of innovative products, which
could have high potential in the future. She suggested that using real options methodology
with traditional investment appraisal methods such as net present value could help
establish a more accurate estimate of the potential value of such companies.

The company has asked its finance team to prepare a report on the value of a potential
target company, Foshoro Co, before making a final decision.

Foshoro Co

Foshoro Co is a non-listed pharmaceutical company established about 10 years ago. Initially

Foshoro Co grew rapidly, but this rate of growth slowed considerably three years ago, after
a venture capital equity backer exited the company by selling its stake back to the founding
directors. The directors had to raise substantial debt capital to buy back the equity stake.
The company’s current debt to equity ratio is 60:40. This high level of gearing means that

29
the company will find it difficult to obtain funds to develop its innovative products in the
future.

The following financial information relates to Foshoro Co: Extract from the most recent
statement of profit or loss

$ million
Sales revenue 878·1
Profit before interest and tax 192·3
Interest 78·6
Tax 22·7
Profit after tax 91·0

In arriving at the profit before interest and tax, Foshoro Co deducted tax allowable
depreciation and other non-cash expenses totalling $112·0 million. It requires a cash
investment of $98·2 million in non-current assets and working capital to continue its
operations at the current level.

Three years ago, Foshoro Co’s profit after tax was $83·3 million and this has been growing
steadily to their current level. Foshoro Co’s profit before interest and tax and its cash flows
grew at the same growth rate as well. It is likely that this growth rate will continue for the
foreseeable future if Foshoro Co is not acquired by Chikepe Co. Foshoro Co’s cost of capital
has been estimated at 10%.

Combined company: Chikepe Co and Foshoro Co

Once Chikepe Co acquires Foshoro Co, it is predicted that the combined company’s sales
revenue will be $4,200 million in the first year, and its operating profit margin on sales
revenue will be 20% for the foreseeable future.

30
After the first year, the sales revenue is expected to grow at 7% per year for the following
three years. It is anticipated that after the first four years, the growth rate of the combined
company’s free cash flows will be 5·6% per year.

The combined company’s tax allowable depreciation is expected to be equivalent to the

amount of investment needed to maintain the current level of operations. However, as the
company’s sales revenue increases over the four-year period, the combined company will
require an additional investment in assets of $200 million in the first year and then $0·64
per $1 increase in sales revenue for the next three years.

It can be assumed that the asset beta of the combined company is the weighted average of
the individual companies’ asset betas, weighted in proportion of the individual companies’
value of equity. It can also be assumed that the capital structure of the combined company
remains at Chikepe Co’s current capital structure level, a debt to equity ratio of 30:70.
Chikepe Co pays interest on borrowings at a rate of 5·3% per annum.

Chikepe Co estimates that it will be able to acquire Foshoro Co by paying a premium of 30%
above its estimated equity value to Foshoro Co’s shareholders.

Other financial information

Equity beta Asset beta

Chikepe Co 1·074 0·800

Foshoro Co 2·090 0·950

The current annual government borrowing base rate is 2% and the annual market risk
premium is estimated at 7%.

Both companies pay tax at an annual rate of 20%.

Chikepe Co estimates equity values in acquisitions using the free cash flow to firm method.

Future acquisitions

The BoD agreed that in the future it is likely that Chikepe Co will target both listed and non-
listed companies for acquisition. It is aware that when pursuing acquisitions of listed
companies, the company would need to ensure that it complied with regulations such as the
mandatory bid rule and the principle of equal treatment to protect shareholders. The BoD is
also aware that some listed companies may attempt to defend acquisitions by employing
anti-takeover measures such as poison pills and disposal of crown jewels.

Required:

(a) Compare and contrast the reasons for the opinions held by Director A and by Director
B, and discuss the types of synergy benefits which may arise from the acquisition strategy
suggested by Director B. (9 marks)

31
(b) Discuss how using real options methodology in conjunction with net present value
could help establish a more accurate estimate of the potential value of companies, as
suggested by Director C. (5 marks)

(c) Prepare a report for the board of directors of Chikepe Co which:

(i) Estimates the current equity value of Foshoro Co; (6 marks)

(ii) Estimates the equity value arising from combining Foshoro Co with Chikepe Co;
(11 marks)

(iii) Evaluates whether the acquisition of Foshoro Co would be beneficial to Chikepe

Co’s shareholders and discusses the limitations of the valuation method used in
(c)(i) and (c)(ii) above. (7 marks)

Professional marks will be awarded in part (c) for the format, structure and presentation
of the report. (4 marks)

(d) Discuss how the mandatory bid rule and the principle of equal treatment protects
shareholders in the event of their company facing a takeover bid, and discuss the
effectiveness of poison pills and disposal of crown jewels as defensive tactics against
hostile takeover bids. (8 marks) (50 marks)

32
Section B – TWO questions ONLY to be attempted

2 Tippletine Co is based in Valliland. It is listed on Valliland’s stock exchange but only

has a small number of shareholders. Its directors collectively own 45% of the equity share
capital.

Tippletine Co’s growth has been based on the manufacture of household electrical goods.
However, the directors have taken a strategic decision to diversify operations and to make a
major investment in facilities for the manufacture of office equipment.

Details of investment

The new investment is being appraised over a four-year time horizon. Revenues from the
new investment are uncertain and Tippletine Co’s finance director has prepared what she
regards as cautious forecasts. She predicts that it will generate $2 million operating cash
flows before marketing costs in Year 1 and $14·5 million operating cash flows before
marketing costs in Year 2, with operating cash flows rising by the expected levels of inflation
in Years 3 and 4.

Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to
4.

The new investment will require immediate expenditure on facilities of $30·6 million. Tax
allowable depreciation will be available on the new investment at an annual rate of 25%
reducing balance basis. It can be assumed that there will either be a balancing allowance or
charge in the final year of the appraisal. The finance director believes the facilities will
remain viable after four years, and therefore a realisable value of $13·5 million can be
assumed at the end of the appraisal period.

The new facilities will also require an immediate initial investment in working capital of $3
million. Working capital requirements will increase by the rate of inflation for the next three
years and any working capital at the start of Year 4 will be assumed to be released at the
end of the appraisal period.

Tippletine Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any
tax losses on the investment can be assumed to be carried forward and written off against
future profits from the investment.

Predicted inflation rates are as follows:

Year 1 2 3 4

8% 6% 5% 4%

33
Financing the investment

Tippletine Co has been considering two choices for financing all of the $30·6 million needed
for the initial investment in the facilities:

– A subsidised loan from a government loan scheme, with the loan repayable at the
end of the four years. Issue costs of 4% of the gross finance would be payable.
Interest would be payable at a rate of 30 basis points below the risk free rate of
2·5%. In order to obtain the benefits of the loan scheme, Tippletine Co would have to
fulfil various conditions, including locating the facilities in a remote part of Valliland
where unemployment is high.
– Convertible loan notes, with the subscribers for the notes including some of
Tippletine Co’s directors. The loan notes would have issue costs of 4% of the gross
finance. If not converted, the loan notes would be redeemed in six years’ time.
Interest would be payable at 5%, which is Tippletine Co’s normal cost of borrowing.
Conversion would take place at an effective price of $2·75 per share. However, the
loan note holders could enforce redemption at any time from the start of Year 3 if
Tippletine Co’s share price fell below $1·50 per share. Tippletine Co’s current share
price is $2·20 per share.

Issue costs for the subsidised loan and convertible loan notes would be paid out of available
cash reserves. Issue costs are not allowable as a tax-deductible expense.

In initial discussions, the majority of the board favoured using the subsidised loan. The
appraisal of the investment should be prepared on the basis that this method of finance will
be used. However, the chairman argued strongly in favour of the convertible loan notes, as,
in his view, operating costs will be lower if Tippletine Co does not have to fulfil the
conditions laid down by the government of Valliland. Tippletine Co’s finance director is
sceptical, however, about whether the other shareholders would approve the issue of
convertible loan notes on the terms suggested. The directors will decide which method of
finance to use at the next board meeting.

Other information

Humabuz Co is a large manufacturer of office equipment in Valliland. Humabuz Co’s geared

cost of equity is estimated to be 10·5% and its pre-tax cost of debt to be 5·4%. These
estimates are based on a capital structure comprising $225 million 6% irredeemable bonds,
trading at $107 per $100, and 125 million $1 equity shares, trading at $3·20 per share.
Humabuz Co also pays tax at an annual rate of 30% on its taxable profits.

Required:

(a) Calculate the adjusted present value for the investment on the basis that it is
financed by the subsidised loan and conclude whether the project should be
accepted or not. Show all relevant calculations. (17 marks)

34
 (b) Discuss the issues which Tippletine Co’s shareholders who are not directors would
consider if its directors decided that the new investment should be financed by the
issue of convertible loan notes on the terms suggested.

Note: You are not required to carry out any calculations when answering part (8 marks)

(25 marks)

35
3 Arthuro Co group

Arthuro Co is based in Hittyland and is listed on Hittyland’s stock exchange. Arthuro Co has
one wholly-owned subsidiary, Bowerscots Co, based in the neighbouring country of Owlia.
Hittyland and Owlia are in a currency union and the currency of both countries is the $.

Arthuro Co purchased 100% of Bowerscots Co’s share capital three years ago. Arthuro Co
has the power under the acquisition to determine the level of dividend paid by Bowerscots
Co. However, Arthuro Co’s board decided to let Bowerscots Co’s management team have
some discretion when making investment decisions. Arthuro Co’s board decided that it
should receive dividends of 60% of Bowerscots Co’s post-tax profits and has allowed
Bowerscots Co to use its remaining retained earnings to fund investments chosen by its
management. A bonus linked to Bowerscots Co’s after-tax profits is a significant element of
Bowerscots Co’s managers’ remuneration.

Bowerscots Co operates in a very competitive environment. Recently, a senior member of

its management team has left to join a competitor.

Arthuro Co’s dividend policy

Until three months ago, Arthuro Co had 90 million $2 equity shares in issue and $135 million
8% bonds. Three months ago it made a 1 for 3 rights issue. A number of shareholders did
not take up their rights, but sold them on, so there have been changes in its shareholder
base. Some shareholders expressed concern about dilution of their dividend income as a
result of the rights issue. Therefore, Arthuro Co’s board felt it had to promise, for the
foreseeable future, at least to maintain the dividend of $0·74 per equity share, which it paid
for the two years before the rights issue.

Arthuro Co’s board is nevertheless concerned about whether it will have sufficient funds
available to fulfil its promise about the dividend. It has asked the finance director to forecast
its dividend capacity based on assumptions about what will happen in a ‘normal’ year. The
finance director has made the following assumptions in the forecast:

1. Sales revenue can be assumed to be 4% greater than the most recent year’s of $520
million.

2. The operating profit margin can be assumed to be 20%.

3. Operating profit can be assumed to be reported after charging depreciation of $30

million and profit on disposal of non-current assets of $5·9 million. The cost of the
non-current assets sold can be assumed to be $35 million and its accumulated
depreciation to be $24·6 million. Depreciation is allowable for tax and the profit on
disposal is fully chargeable to tax.

4. The net book value of non-current assets at the year end in the most recent
accounts was $110 million. To maintain productive capacity, sufficient investment

36
 to increase this net book value figure 12 months later by 4% should be assumed, in
line with the increase in sales. The calculation of investment required for the year
should take into account the depreciation charged of $30 million, and net book
value of the non-current assets disposed of during the year.

5. A $0·15 investment in working capital can be assumed for every $1 increase in sales
revenue.

6. Bowerscots Co’s pre-tax profits can be assumed to be $45 million.

Arthuro Co’s directors have decided that if there is a shortfall of dividend capacity,
compared with the dividends required to maintain the current dividend level, the
percentage of post-tax profits of Bowerscots Co paid as dividend should increase, if
necessary up to 100%.

Taxation

Arthuro Co pays corporation tax at 30% and Bowerscots Co pays corporation tax at 20%. A
withholding tax of 5% is deducted from any dividends remitted by Bowerscots Co. There is a
bilateral tax treaty between Hittyland and Owlia. Corporation tax is payable by Arthuro Co
on profits declared by Bowerscots Co, but Hittyland gives full credit for corporation tax
already paid in Owlia. Hittyland gives no credit for withholding tax paid on dividends in
Owlia.

Required:

(a) (i) Estimate Arthuro Co’s forecast dividend capacity for a ‘normal’ year; (11 marks)

(ii) Estimate the level of dividend required from Bowerscots Co to give Arthuro Co
sufficient dividend capacity to maintain its dividend level of $0·74 per equity share.
(3 marks)

37
(b) Arthuro Co has decided to increase its level of dividend from Bowerscots Co if its
dividend capacity is insufficient.

Required:

I. From Arthuro Co’s viewpoint, discuss the financial benefits of, and problems with,
this decision; (5 marks)
II. Discuss the agency problems, and how they might be resolved, with this decision.
(6 marks)

(25 marks)

38
4 The Adverane Group is a multinational group of companies with its headquarters in
Switzerland. The Adverane Group consists of a number of fully-owned subsidiaries and Elted
Co, an associate company based in the USA in which Adverane Group owns 30% of the
ordinary equity share capital. Balances owing between the parent, Adverane Co, and its
subsidiaries and between subsidiaries are settled by multilateral netting. Transactions
between the parent and Elted Co are settled separately.

Transactions with Elted Co

Adverane Co wishes to hedge transactions with Elted Co which are due to be settled in four
months’ time in US$. Adverane Co will owe Elted Co US$3·7 million for a major purchase of
supplies and Elted Co will owe Adverane Co US$10·15 million for non-current assets.
Adverane Group’s treasury department is considering whether to use money markets or
exchange-traded currency futures for hedging.

Annual interest rates available to Adverane Co

Investing rate Borrowing rate

Switzerland 2·7% 3·9%

USA 2·5% 3·7%

Exchange traded currency futures

Contract size CHF125,000, price quotation US$ per CHF1

Three-month expiry: 1·1213

Six-month expiry: 1·1204

Netting

The balances owed to and owed by members of Adverane Group when netting is to take
place are as follows:

39
Owed by Owed to Local currency

Adverane (Switzerland) Bosha (Eurozone) CHF15·90

Adverane (Switzerland) Diling (Brazil) CHF4·46

Bosha (Eurozone) Cogate (USA) €24·89

Bosha (Eurozone) Diling (Brazil) €18·57

Cogate (USA) Adverane (Switzerland) US$27·08

Cogate (USA) Diling (Brazil) US$5·68

Diling (Brazil) Adverane (Switzerland) BRL38·80

Diling (Brazil) Bosha (Eurozone) BRL51·20

Spot rates are currently as follows:

CHF € US$ BRL

1 CHF = 1·0000 0·9347–0·9369 1·1196–1·1222 3·1378–3·1760

The group members will make settlement in Swiss francs. Spot mid-rates will be used in
calculations. Settlement will be made in the order that the company owing the largest net
amount in Swiss francs will first settle with the company owed the smallest net amount in
Swiss francs.

Transfer price arrangements

The Adverane Group board has been reviewing the valuation of inter-group transactions, as
it is concerned that the current system is not working well. Currently inter-group transfer
prices are mostly based on fixed cost plus a mark-up negotiated by the buying and selling
divisions. If they cannot agree a price, either the sale does not take place or the central
treasury department determines the margin. The board has the following concerns:

– Both selling and buying divisions have claimed that prices are unfair and distort the
measurement of their performance.

– Significant treasury department time is being taken up dealing with disputes and
then dealing with complaints that the price it has imposed is unfair on one or the other
division.

– Some parts of the group are choosing to buy from external suppliers rather than
from suppliers within the group.

40
As a result of the review, the Adverane Group
board has decided that transfer prices should in
future be based on market prices, where an external market exists.

Note: CHF is Swiss Franc, 3 is Euro, US$ is United States dollar and BRL is Brazilian Real.
Required:

(a) Advise Adverane Co on, and recommend, an appropriate hedging strategy for the
US$ cash flows it is due to receive from, or pay to, Elted Co. (9 marks)

(b) (i) Calculate the inter-group transfers which are forecast to take place. (7 marks)

(ii) Discuss the advantages of multilateral netting by a central treasury function within the
Adverane Group. (3 marks)

(c) Evaluate the extent to which changing to a market-price system of transfer pricing
will resolve the concerns of the Adverane Group board. (6 marks)

(25 marks)

41
42
43
 Present Value Table
Present value of an annuity of 1 i.e. 1 – (1 + r)–n
Where r = discount rate
n = number of periods
Discount rate (r)
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
1 0-990 0-980 0-971 0-962 0-952 0-943 0-935 0-926 0-917 0-909 1
2 0-980 0-961 0-943 0-925 0-907 0-890 0-873 0-857 0-842 0-826 2
3 0-971 0-942 0-915 0-889 0-864 0-840 0-816 0-794 0-772 0-751 3
4 0-961 0-924 0-888 0-855 0-823 0-792 0-763 0-735 0-708 0-683 4
5 0-951 0-906 0-863 0-822 0-784 0-747 0-713 0-681 0-650 0-621 5
6 0-942 0-888 0-837 0-790 0-746 0-705 0-666 0-630 0-596 0-564 6
7 0-933 0-871 0-813 0-760 0-711 0-665 0-623 0-583 0-547 0-513 7
8 0-923 0-853 0-789 0-731 0-677 0-627 0-582 0-540 0-502 0-467 8
9 0-914 0-837 0-766 0-703 0-645 0-592 0-544 0-500 0-460 0-424 9
10 0-905 0-820 0-744 0-676 0-614 0-558 0-508 0-463 0-422 0-386 10
11 0-896 0-804 0-722 0-650 0-585 0-527 0-475 0-429 0-388 0-350 11
12 0-887 0-788 0-701 0-625 0-557 0-497 0-444 0-397 0-356 0-319 12
13 0-879 0-773 0-681 0-601 0-530 0-469 0-415 0-368 0-326 0-290 13
14 0-870 0-758 0-661 0-577 0-505 0-442 0-388 0-340 0-299 0-263 14
15 0-861 0-743 0-642 0-555 0-481 0-417 0-362 0-315 0-275 0-239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0-901 0-893 0-885 0-877 0-870 0-862 0-855 0-847 0-840 0-833 1
2 0-812 0-797 0-783 0-769 0-756 0-743 0-731 0-718 0-706 0-694 2
3 0-731 0-712 0-693 0-675 0-658 0-641 0-624 0-609 0-593 0-579 3
4 0-659 0-636 0-613 0-592 0-572 0-552 0-534 0-516 0-499 0-482 4
5 0-593 0-567 0-543 0-519 0-497 0-476 0-456 0-437 0-419 0-402 5
6 0-535 0-507 0-480 0-456 0-432 0-410 0-390 0-370 0-352 0-335 6
7 0-482 0-452 0-425 0-400 0-376 0-354 0-333 0-314 0-296 0-279 7
8 0-434 0-404 0-376 0-351 0-327 0-305 0-285 0-266 0-249 0-233 8
9 0-391 0-361 0-333 0-308 0-284 0-263 0-243 0-225 0-209 0-194 9
10 0-352 0-322 0-295 0-270 0-247 0-227 0-208 0-191 0-176 0-162 10
11 0-317 0-287 0-261 0-237 0-215 0-195 178 0-162 0-148 0-135 11
12 0-286 0-257 0-231 0-208 187 0-168 152 0-137 0-124 0-112 12
13 0-258 0-229 0-204 0-182 163 0-145 130 0-116 0-104 0-093 13
14 0-232 0-205 181 0-160 141 0-125 111 0-099 88 0-078 14
15 0-209 0-183 160 0-140 123 0-108 95 0-084 0-074 0-065 15

44
 Annuity Table
Present value of an annuity of 1 i.e. 1 – (1 + r)–n/r
Where r = discount rate
n = number of periods
Discount rate (r)
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(n)
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

45
 Standard normal distribution table
0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09
0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879
0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2704 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389
1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015
1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177
1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319
1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441
1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545
1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767
2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936
2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986
3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990
This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above
from 0·5.

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