Instructor: Bagher Modjtahedi, Department of Economics, College of Letters and Science
Description: An option is a right, but not an obligation, to do something. A financial option is an option to buy or sell a financial asset such as a share of common stock or a foreign exchange. These options are traded in organized exchanges. A “real” option is an option to do something real—i.e., non-financial. All non-financial decisions that you can postpone fall in this category. Examples include the decision to buy a new car or sell the old one, acquire a new company or sell part of the existing one, invest in a new line of business, start a new research-and-development project, and so on. Some economists would extend the examples to include options to marry, divorce, or even commit suicide. Options are valuable. An option is more valuable if the future is more uncertain, the cost of taking the action is greater, and the decision is irreversible. One of the most exciting developments in the fields of economics and finance in the last thirty years has been derivation of formulas to estimate the values of such options. Some economists have likened the initial derivation of the options-valuation formula by economists Fisher and Sholes to the discovery of the DNA formulas. Corporations are learning more and more to use these techniques. As they say, real options are the wave of the future. The class will focus on the application of these methodologies to such business decisions as investment projects, expanding or contracting existing projects, acquiring other firms, selling a part of the business, and so on.
Prerequisite: High school algebra and familiarity with Excel spreadsheet.
Format: The emphasis will be on the interaction between theory and practice. I am sure you will enjoy the hands-on nature of the class. I will show you how to use Excel to do sophisticated Monte-Carlo simulations to find the values of real options. We will meet two hours each week. The first hour I will lecture on the requisite theory, the second hour we will put the theoretical knowledge to work using Excel modeling. We will start with the rudiments of statistics, portfolio optimization theories, and discounted cash flow analyses. We will then move to options valuation methodologies including the Black-Scholes formulas and risk-neutral probability approaches. Grading: Grading will be based on four problem sets (10% each), class attendance, participation, and discussion (20%), and a final exam (40%).
About the Instructor: The instructor received his master’s degree in quantitative economics from the University of East Anglia (UK) and his PhD in economics from UC Davis. His research interests and publications have centered on pricing of forward foreign exchange rates as well as energy financial derivatives such as oil and natural-gas futures prices. He has also practical experience in financial and business valuation. In this field he specializes in the valuation of restricted assets—those that the owner cannot sell for some time for regulatory reasons. Options valuation also applies to pricing of such assets.