Past Papers - Examiner's Solutions June 2008 Question 1 You run an investment company and an interesting proposition has arrived on your desk. There is a property investment company that is about to invest £2.3m in a project. They do not have all the funding in place. You offer to provide them with the cash they need to complete the funding by buying a call option, with an exercise price of £2.2m from them on the development. You have researched the proposal and believe that the project will pay off either £2.7m or £2.1m in six months time; with each outcome having a probability of 0.5, no other outcomes are possible. The annual interest rate is 4.25%. Required: a. How much should you pay for this option? (6 marks) b. If there was a put option available on this project, how much should it cost? (4 marks) c. Draw a payoff diagram for the original option strategy in part (a). (3 marks) d. Identify and discuss examples of the main categories of real options and explain how you would use and analyse real options. (7 marks) e. It is often said that the equity in a geared company resembles a call option. Using the Black– Scholes variables discuss how the model works in general. (6 marks) f. Your company also uses large amounts of cocoa in producing chocolate products. Describe how you could use the futures market to protect yourself as a buyer of cocoa and draw the payoff diagram for your futures strategy. (4 marks) Case Solution 1 (a) How much should you pay for this option? (6 marks) S0 up price = down price = u d Cu Cd X rf t Y= Z= C0 = Finance Edinburgh Business School 2 300 2 700 2 100 1.174 0.913 500 max (0, [u × S0] − X) 0 max (0, [d × S0] − X) 2 200 0.0425 0.5 0.833333 − 1 713.96 £202 710 1 Past Papers - Examiner's Solutions / June 2008 The figures above are in thousands. You would pay £202 710 for this six-month option. (b) If there was a put option available on this project, how much should it cost? (4 marks) The put is priced by using the put–call parit

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