Citic Tower

CITIC Tower II: The Real Option

finance II

Prof. a. KANAGRAJ

Ashwani Raj

2009PGP049d

ASSIGNMENT 1

Executive Summary:

The problem that is being faced in the case is regarding rigid assumptions in evaluating the investment decision.

Following are the alternatives that can be used to address the problem

NPV

Net present value (NPV) or net present worth (NPW)[1] is defined as the total present value (PV) of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

Option pricing

We generally describe options in terms of the cash flow payoffs we receive on them. The buyer of a call option gets the right to buy the underlying the underlying asset at affixed price, where as the buyer of a put option obtains the right to sell the underlying asset at a fixed price. Generally the determinants of the option value are considered and introduce a model for pricing options. When the underlying asset’s price follow a binomial path , we can also analyze it based on alternatives to the binomial model and extensions to value options with special features.

Alternatives to the binomial model

In the binomial option pricing model, the underlying asset and risk free lending or borrowing are combined to create a portfolio that had the same cash flows as the option being valued; we called this portfolio the replicating portfolio. Although the binomial model provides the intuitive feel for the determinants of the option value, it requires a large number of inputs in terms of expected future prices at each node. As we can make time periods shorter in the binomial model, we can make assumptions about asset prices. We can assume that price changes becomes smaller as time periods approaches zero leading to continuous price...