Sally Jameson

Graded Case 2 |

Sally Jameson |

Capital Markets & Financing |

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5/25/2010 |

1) Valuation of Option Package

In order to decide whether Sally Jameson should opt for cash or options on Telstar, we calculated the value of the 5-year call options first. While we are given information on realized volatility (Exhibit 3) over the 1982-1992 periods, we did not have information on implied volatility which should be used for the option valuation. While realized volatility is a useful metric, it is backward-looking hence is not used directly in pricing.

In order to get implied volatility, we used the Black-Scholes model to work back the implied volatility in the longest dated call options available in Exhibit 1. We plugged in the expiration date, strike price, option premium, 2-year interest date and the stock spot level for the January 22, 1994 expiry, $12.50, $17.50 and $20-strike call options priced at $7.75, $4.625 and $3.75 to solve for the 2-year implied volatility in the stock. Using the model, we got an average of the implied volatility of 35.93% (see Appendix I).

It is important to note that 2-year implied volatility level can be very different than the 5-year implied volatility level, which would be the actual level we would need to use in order to price the 5-year call option. Term structure of volatility could be shifting at any point in time, however using the 2-year level we have ignored any possible changes in the lack of more information.

Since the case states that the company does not pay dividends, we didn’t have to worry about a possible dividend being paid between today and the maturity of the option which would have otherwise affected our forward level and the pricing of our option.

Once we got the average implied volatility, we used the Black and Scholes formula again to calculate the premium of the 5-year, $35-strike (deep-out of the money) call options. In our calculation we used the 5-year interest rate of 6.02%, which...