Chapter 15

Arbitrage and Option Pricing Theory

Arbitrage pricing theory is an alternate to CAPM

Option pricing theory applies to pricing of
contingent claims
Both have applications for capital budgeting and
financing
Both are based on the arbitrage pricing principle

Arbitrage pricing principle

Principle: In an efficient market identical sets of

benefits sell at identical prices
One way to define the set of benefits is in terms of
identical probability distributions of returns
Two ways of creating the same probability
distribution of future cash flows should have the
same current price and therefore the same
expected return

Arbitrage Pricing Theory

Foundation for the theory is the arbitrage pricing

principle
Based on a much less restrictive set of
assumptions than CAPM

Arbitrage principle holds

Markets are efficient

Arbitrage Pricing Theory

Standard (Ross) APT

E(Rs)=Rf+[E(R1)Rf]s,1+[E(R2)Rf]s,2
++[E(Rn)Rf]s,n

Where
E(Rs)=Expectedreturnforanasset
E(Ri)=Expectedreturnonaportfoliowith
unitarysensitivitytofactornandzero
sensitivitytootherfactors
s,i=Betaoftheassetwithregardtofactori

Application of the Ross APT

Unitary sensitivity portfolios can be created from

publicly available securities
Some suggested factors

Industrial production or return on the market portfolio

Changes in the risk premium between high-grade and
lower-grade bonds
Slope of the yield curve
Unanticipated inflation

Application of the Ross APT

The difficulty is in identifying factors and

economic surrogates for those factors
This difficulty has limited application

State-based Arbitrage Analysis of

Capital Investments

Often identify various possible states of the world

and compute the cash benefits for a capital
investment in each of these states
We might also estimate returns for a variety of
stock investment portfolios in each state

State-based Arbitrage Analysis of

Capital Investments

We can replicate the cash flows of the proposed

capital investment with publicly traded securities
The NPV of the capital investment = cost of
replicating the cash flows - cost of the capital
investment
A key advantage is that state-based arbitrage
analysis does not require the identification of
probabilities

Option Pricing Models

Option pricing models are also based on the

arbitrage pricing principle
Option pricing models are based on the fact that
options can generally be combined with purchase
or sale of the underlying asset to create a risk-free
investment
In equilibrium, the price of the option must be
such that this risk-free investment pays the riskfree rate of return

Option terminology

Calloption:anoptiontobuyanasset.
Putoption:anoptiontosellanasset.
Exerciseofanoption:thebuyingorsellingofthe
assetasprovidedforintheoptioncontract.
Exerciseprice(strikingprice):thepriceat
whichtheassetcanbeboughtorsold,asstatedin
theoptioncontract.

Option terminology

Expirationdate:thelastdayonwhichtheoption
maybeexercised.
Europeanoption:anoptionthatmaybe
exercisedonlyontheexpirationdate.
Americanoption:anoptionthatmaybe
exercisedatanytimepriortoitsexpirationdate.

Option Terminology

Writer:thepersonwhosellsanoptioncontractto
another,therebygrantingthebuyeranoptionto
buyorselltheassetattheexercisepriceunderthe
termsspecifiedinthecontract.

Two-state Option Valuation

Value of a call option:

C = [So Sd/(1+Rf)](Su E)/(Su Sd)
Where
C = Value of a call option
So = current price of the underlying stock
Su, Sd = higher and lower of two possible prices for the
stock at the end of the period
E = Exercise price of the option
Rf = Risk-free rate

Black-Scholes Model
C=SoN(d1)[EeRfT]N(d2)
Where
So=currentpriceofthestock
E=exercisepriceoftheoption
Rf=riskfreerate,continuouslycompounded
N(di)=thevaluefromthetableofthenormaldistribution
representingtheprobabilityofanoutcomelessthand i
d1=[ln(So/E)+(Rf+.5S2)T]/(ST)
d2=d1(ST)
S=standarddeviationofthecontinuouslycompounded
annualrateofreturnforthestock
T=timeinyearsorfractionsofyearsuntilexpirationofoption
e=2.71828...,thebaseofthenaturallogarithm

Real Options

Many capital investments are real options

R & D investment creates the option to invest in

production
Can value using a two-state model or Black-Scholes

Financing Choices as Options

Stock

Stockholders of a leveraged firm have the option of

paying the creditors and buying the company or
turning the company over to the creditors. The exercise
price of the option is thus the amount owed to creditors.

Debt

Creditors essentially own the company, and have

written an option which can be exercised by the
stockholders.

Financing Choices as Options

For an unlevered firm, increasing standard

deviation of the probability of asset returns without
increasing the expected return will decrease value
as long as any of that risk is systematic
For the levered firm, increased standard deviation
may increase the wealth of the stockholders at the
expense of the bondholders
This leads to agency costs

Motivating Managers to Take Risks

Managers often receive a combination of a fixed

salary and stock options
The fixed salary is similar to holding debt
instruments in that the return is realized as long as
the firm is solvent
Increased standard deviation of asset returns may
increase or decrease the wealth of managers
depending on the mix of salary and options in their
compensation package

Exchange Rate Risk

Translation risk is the risk that the company will

report lower income because unfavorable
exchange rate movements decrease the U.S. dollar
value of foreign income
Transaction risk is the risk that actual dollar
amount of cash flows coming from international
activities will be smaller because of changes in
exchange rates

Managing Exchange Rate Risk

Currency future: contract to exchange a specific

amount of one currency for a specific amount of
another currency at a designated future date
Currency swap: spot transaction in one direction
offset by futures contract in the opposite direction;
often used when direct futures are not available
Options: the right but not the obligation to exchange
one currency for another at a specified future date