An option is a derivative contract that provides a party the right to buy or sell an underlying asset at a fix price by a certain time in future, the party holding the right is an option buyer while the party granting the right is the option seller or option writer. The option buyer pays the seller an amount called option price or premium.
Types of Options
There are two types of options;
1. Call Option
A call option is an option granting the right to buy the underlying asset.
2. Put Option
A put option is an option granting the right to sell the underlying asset.
The price at which the option holder could buy or sell is called the exercise price or strike price.
The options can be:
European Style Option: The European style option can be only exercised on maturity.
American Style Option: The American style option can be exercised on any day before expiration.
Option can result in the delivery of an underlying asset or cash settlement at the maturity. Options are traded on exchanges meaning that exchange sets everything for example the units of the underlying asset and time to maturity etc. While the traders only establish the price of an underlying asset. In options the credit risk is unilateral while in forwards it is bilateral. Essentially the credit risk is in exchange listed option is zero because clearing house guarantees of payment to buyers. Option is one debt instrument that carries more risk as compare to traditional debt used by the multinational company. Since the option is the right and not the obligation. So the holder can choose not to exercise the right and let the option expire.
The Use of Options in Projects or Investment
One of the major limitations of the investment analysis including NPV, IRR, and payback period is that these models are static and does not offer good solutions to capture the impacts of options. These options are an integral part of the investment and the use of the options makes sometimes unviable projects viable in future.
- The first of these options is the option to delay investment or project. When the company has exclusive right for a project.
- The second option is you take one investment but you have an opportunity to take the other investment in future also.
- The third option is the option of abandon. If the cash flows of the project does not match the outflows.
All these three options are used to add value to a bad project.
December 05, 2018