Options Can Be Valued: It's Time for Generally Accepted Option Valuation Principles. (Special Section: Stock Options)

By King, Alfred M.; Parrish, Summer | Strategic Finance, October 2002 | Go to article overview

Options Can Be Valued: It's Time for Generally Accepted Option Valuation Principles. (Special Section: Stock Options)


King, Alfred M., Parrish, Summer, Strategic Finance


EVER SINCE ELCONOMISTS Fischer Black, Myron Scholes, and Robert Merton derived a formula for pricing options, tens of thousands of investors have bought and old options in the financial markets. Every day The Wall Street Journal has a column about options. The Chicago Board Options Exchange (CBOE) trades options, and the resultant prices are listed in the daily press.

To say that options can't be valued flies in the face of economic reality. The can be valued. They are valued. Money changes hands every day between willing buyers and willing sellers, and both sides of each transaction are acting in their own self-interest. There is no compulsion on either party. While it's difficult to prove, there is no evidence in the options market of the types of shenanigans that periodically have spoiled other markets.

Black-Scholes--Just What Is It?

The Black-Scholes option-pricing formula is the solution to the Black-Scholes-Merton differential equation under specific boundary conditions. Unfortunately, the result is not directly intuitive to nonmathemeticians, but there are numerous textbooks and articles that derive the formula if you want to look further. You only need to obtain a flavor of what Black-Scholes is about to understand the issues, and you don't have to be able to derive the formula mathematically in order to be able to use it effectively.

(see sidebar, p. 53).

Here we're only looking at what an option is and the variables that influence its value. You can take the formula on trust. If you want to see a straight application of the formula to any option valuation, you can go to http://www.blobek.com/black-scholes.html, which has a calculator you can use for free. Enter the variables, and the computer will give you the value. For a history of the Black-Scholes model and the chance to test your skill at managing a pretend portfolio without risking any money, visit www.pbs.org. Search by the subject "Business & Finance," and then click on NOVA: Trillion Dollar Bet.

KEY POINTS

Here are the key points about option valuation that you as a finance manager need to know.

* An option is a contract that gives the holder the right to acquire an underlying security, at a fixed price, for a period of time.

* An option is itself a derivative security, and its value depends on the price of the underlying stock.

The holder can exercise the option if it's favorable to do so but can let the option expire unexercised if it isn't beneficial.

* The option is marketable. That is, the holder has the choice of exercising it or selling the option to someone else.

* If the option is exercised, then the underlying stock can be sold immediately.

* The more volatile the underlying stock, the more valuable the option. This is because a more volatile stock is more likely to fluctuate and at some point be above the exercise or strike price.

* The longer the duration of the option contract, the more opportunity there is to realize value from exercising the option, so the option is more valuable. An option that expires next week to buy stock at $40 when the stock today is $35 is not worth much. An option with the same strike or exercise price and market price that still has 10 years to run will be quite valuable.

* Dividends paid on the common stock reduce the value of options. Option holders don't own the underlying security directly, so they don't receive dividends.

When the Financial Accounting Standards Board (FASB) issued its guidelines for stock options (Statement of Accounting Standards (SFAS) No. 23, "Accounting for Stock-Based Compensation"), it suggested that the valuation of stock options be performed by utilizing Black-Scholes or some other option-pricing model. There are, in fact, several different option-pricing models, but they usually provide very similar answers. We focus on the popular and oft-relied-upon Black-Scholes model. …

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