One of the things I am commonly called on to do it to look at option valuations to see whether they are appropriate and likely to be correct. These are often prepared by an accounting firm or a consultancy. This is normally for a fee of around $1,500 to $2,000 – or even more in some cases.
These are often done for audit purposes, to ensure that the options are (materially) correctly valued for presentation in the financial accounts. Some good news here if you are looking at doing this – you can do it yourself and save (almost) all of the money.
The usual reason for doing this is that “options valuations are normally best left to experts” or “they are too difficult”. Twaddle. I have seen plenty of “expert” valuations that are just plain wrong because they have not tried to understand the nature of the options to be valued. Even if unlisted you can still do it.
All you need is an appropriate excel plug in (Hoadley’s is a good one – and only AUD99), a time series of share prices (your own if listed, a close proxy if not) and some time.
The parameters you need to value an option are:
- strike price of the option (the cost to exercise it)
- value of the underlying (the actual stock price at the date needed for the valuation)
- the period to expiry (the time from the date for the valuation to when the option expires)
- the risk free rate of interest (the government bond rate – not the spot rate, but one with a similar maturity as the option)
- any expected dividends to be paid
- the type of option (if it can only be exercised on the expiry date – European, at any time – American, on certain dates – Bermudan)
- the expected volatility of the stock over the period to expiry.
- any other conditions, including such things as barriers – where it can only be exercised if the share price goes over a certain amount.
The only one of these that will cause some debate is the volatility – the propensity of the value of the shares to vary in value. Most of the time this is measured by taking the backwards volatility and then saying why it is – or is not – appropriate going forward. To get the historical volatility you need a stock price history – go to yahoo finance for that. Then calculate it using the formulae in Hoadleys (HoadleyHistoricVolatility). For a small listed company, look for values around 100%, with larger companies typically less volatile than that.
Another quick note – if you are doing this for employee share options under AASB2 you are allowed to chop down the time to expiry if you expect the options to be early exercised. Just be prepared to justify that.
Plug all the data into your option value calculator (HoadleyOptions1) for a normal option or one of the others (e.g. HoadleyBarrier1 if the option has a price performance target).
Print out the results, along with any justification you have for your volatility difference from historical and then it is your auditor’s turn to try to come up with another number if they disagree.
6 comments
12 March, 2007 at 21:25
Riskopedia
Just a note to, for people interested in more on the “mathematics” side of option pricing, the basic is to look at Black and Scholes option pricing Model (if you seriously want to save $99) . You can go to http://bradley.bradley.edu/~arr/bsm/model.html , or google it.
Agree with Ozrisk, volatity is always the hard part, very subjective.
12 March, 2007 at 22:19
ozrisk
Thanks for that, riskopedia – I just enjoy having an excel plug in. Old habits die hard.
13 March, 2007 at 15:17
Steve Edney
Vol is the hard part as it is essentialy a free pricing parameter. For liquid options vol is determined by the price an option is trading at not the reverse.
However Ozrisk is right for options that aren’t being actively traded, historical vol is what you must use and should be acceptable in those cases. I would also be concerned as an auditor for sold, out of the money
options that some effort to reflect a volatility smile had been used. BS using historical vols won’t price out of the money options very well.
13 March, 2007 at 15:58
ozrisk
Thanks for that, Steve – you are right. I have spent a fair chunk of time over the last few weeks looking at employee share option valuations – which are essentially all unlisted bought calls. Most of these have been in the money – particularly for those in the listed resource sector. Whether that will last is another question.
I just look at some of the fees being charged to value some of these – and the questionable results – and think that a person with a brain, a spreadsheet with the appropriate add-ins and some data could have done better and for a lot less.
13 March, 2007 at 16:31
Steve Edney
No you are right. Vanilla options aren’t complicated and you should be able to do them yourself with some cheap software.
13 March, 2007 at 16:35
Steve Edney
I also doubt from experience that the average accountancy or consultancy is down with pricing of the vol smile, but its certainly an issue that people should be aware of, selling out of the money options and poor smile valuation is one of the things that got NAB options desk in trouble to begin with.