What is distinctive about an option security? ✓ Solved

This case was prepared by Kathleen Hevert, Associate Professor of Finance at Babson College, based on published sources. It was developed as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. No part of this publication can be reproduced, stored or transmitted in any form or by any means without prior written permission of Babson College. Blue Heron Capital Partners, LLC was a socially responsible investment management firm offering investment vehicles ranging from low volatility traditional benchmark products to aggressive growth funds.

Blue Heron recently had launched a hedge fund, one of a rare but growing breed of socially responsible investment (SRI) vehicles. A hedge fund uses leverage, derivatives and long and short equity positions to satisfy its risk and return objectives. Blue Heron’s fund managers screened companies for social responsibility and then selected instruments and positions based on performance. A recent opportunity scan had identified two companies – AstraZeneca plc and Medco Health Solutions, Inc. – satisfying Blue Heron’s strict selection criteria. Blue Heron’s hedge fund manager was considering incorporating options on AstraZeneca and Medco into her portfolio.

AstraZeneca plc Overview

AstraZeneca [LSE: AZN] was engaged in research, manufacture, and sale of pharmaceuticals and biopharmaceuticals. The company was committed to sustainable development of its business and the delivery of medicines, with the goals of making a difference in the lives of patients and creating value for shareholders and society. It concentrated its efforts in six therapy areas – cancer, cardiovascular, gastrointestinal, infection, neuroscience and respiratory & inflammation – which together accounted for the world’s most serious diseases. The company addressed the environmental impacts of the drugs it designed in a top-down approach that included manufacture and use. AstraZeneca performed life cycle assessments on the most important solvents used in its manufacturing processes and provided its development chemists and engineers with guidance on selecting solvents and choosing raw materials to minimize environmental impact.

AstraZeneca also adhered to a comprehensive climate change strategy that highlighted manufacturing, building design, and transport. Its brand names included Arimidex, Crestor, Nexium, Seroquel and Symbicort. AstraZeneca operated 26 manufacturing facilities in 18 countries. Headquartered in London, it employed over 65,000 people.

Medco Health Solutions, Inc. Overview

Medco [NYSE: MHS] was the nation's leading pharmacy benefit manager. Covering one in five Americans, its prescription drug benefit programs were designed to reduce pharmacy health costs for private and public employers, health plans, labor unions, government agencies, and individuals served by the Medicare Part D Prescription Drug Program. Medco served the unique needs of patients with chronic and complex conditions including diabetes, arthritis, high blood pressure, and high cholesterol.

In 2008, it was honored with the top spot in Fortune magazine’s “America’s Most Admired Companies” in the “Health Care: Pharmacy and Other Services” sector. It was ranked number one in the Social Responsibility category within that sector. Medco consolidated all corporate social responsibility undertakings into its Medco Foundation, where activities were organized into four main areas: community capacity building, community economic development, environmental sustainability program, and disaster aid. Medco employed almost 21,000 and was headquartered in Franklin Lakes, New Jersey.

The Analysis

On Monday morning, July 21, 2008, an analyst in Blue Heron’s hedge fund group was preparing an analysis of the value of select options so that she could determine whether these options were fairly valued in the marketplace. She began by collecting data for selected calls and puts for the most recent trading day. She also had collected the data on current interest rates. She knew that, to estimate the value of an option, she needed to come up with an estimate of the volatility of the underlying instrument. She also knew that dividends expected to be paid before an option’s expiration date affected the value of the option, but she could not recall why or how.

Medco shares did not pay dividends, but AstraZeneca shares historically had paid dividends twice a year, in March and September. The next AstraZeneca dividend was expected to be paid on September 15, 2008, to holders of record on August 8. On July 18, shares of AstraZeneca and Medco closed at $45.24 and $45.18, respectively.

Assignment Questions

  1. What is distinctive about an option security? Can calls and puts be valued using the traditional discounted cash flow model (DCF) model? Why or why not?

  2. Consider the Medco call option with a $40 exercise price and an October expiration. Using the riskless hedge approach and monthly binomial trials what is this option worth today? In order to build the binomial tree, you need to estimate the volatility for Medco.

  3. Now consider the Medco call option with an exercise price of $40 and a January expiration. Using the riskless hedge approach and monthly binomial trials, what is the option worth today? How do you explain the difference between values for the October and January calls?

  4. What is the value of the Medco call option with a $40 exercise price and an October expiration using the Black Scholes option pricing model? Why does this value differ from the value using the binomial approach?

  5. Let us now turn to the AstraZeneca call option with a $40 exercise price and an October expiration. Using the riskless hedge binomial approach and the Black Scholes option pricing model, what is this option worth?

  6. How does the September dividend expected from AstraZeneca affect the valuation? Validate your prediction using the Black Scholes option pricing model.

Paper For Above Instructions

Options are unique financial instruments that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. This distinctive characteristic sets options apart from traditional securities like stocks or bonds. Specifically, options can be categorized into two types: calls and puts. A call option allows the holder to purchase the underlying asset, while a put option enables the holder to sell the underlying asset. Due to this inherent right, options are not valued like standard securities using traditional discounted cash flow (DCF) models, which focus primarily on future cash flows and intrinsic values.

The traditional DCF model is based on the idea of estimating the future cash flows of an asset and discounting them back to present value using an appropriate discount rate. However, options derive their value not just from the expected cash flows but also from various risk factors, mainly volatility and time value. This reality necessitates specialized valuation models such as the Black-Scholes model or binomial pricing methods, which account for the unique risk profiles associated with options.

1. Distinctive Features of Option Securities: The primary distinctive feature of option securities is the asymmetry of risk and reward. The holder of an option can leverage a relatively small amount of capital to control larger positions, potentially leading to significant profits if the market moves favorably. Conversely, the maximum loss is limited to the premium paid for the option. This asymmetric risk profile makes options attractive as hedging instruments.

2. Valuation of Medco Call Option: To assess the worth of the Medco call option with a $40 exercise price and an October expiration, the riskless hedge approach and monthly binomial trials can be employed. Estimating the volatility for Medco involves calculating the daily returns from historical price data. This can be achieved by computing the percentage change of the adjusted prices over a one-year period. For instance, if we derive a standard deviation of daily returns from the data, it can be annualized by multiplying by the square root of the number of trading days, generally approximated to 260.

The worth of the Medco call option can then be approximated utilizing the constructed binomial tree, where we would show possible stock price paths, account for any associated probabilities, and derive the expected value of the option under different scenarios.

3. Differences in Call Option Values: The valuation for the Medco call option priced for October would likely differ from that of the January expiration due to the variance in time until expiration and the impacts of volatility. The longer time horizon for the January call introduces additional time value, lending to a higher premium associated with the option. Moreover, market conditions could fluctuate leading up to January, thus altering the perceived value and resulting in differential pricing.

4. Black-Scholes Model Valuation: The Black-Scholes model provides an alternative valuation methodology based on defining the parameters of the call option. Input parameters such as the risk-free interest rate, stock price, strike price, time to expiration, and historical volatility contribute to this pricing model. Identifying the value of the Medco call option using Black-Scholes may yield a figure that varies from the binomial pricing approach due to differing assumptions about market behavior and the treatment of volatility.

5. AstraZeneca Call Option Valuation: To analyze the AstraZeneca call option with a $40 exercise price and October expiration, utilizing both the riskless hedge binomial approach and the Black-Scholes model allows for comprehensive insights. The expected unavailability of adverse impacts from dividend payouts simplifies the immediate analysis. However, the valuation gathered through these methodologies would typically show upward bias in pricing due to positive sentiment about AstraZeneca operations compared to Medco.

6. Impact of Dividends on Valuation: For AstraZeneca, the anticipated dividend could lead to variations in expected returns, influencing option pricing. A key observation with dividend-paying stocks in Black-Scholes is the complexity encounters when factoring dividends into the valuation process due to their forward-looking nature. While dividends typically decrease an option's price as they lead to a decrease in the underlying stock price upon distribution, they must be modeled to accurately reflect their impact on perceived value.

References

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