Option valuation models
Option valuation models use mathematical techniques to identify a range of possible future share prices at the exercise date. From these possible future share prices, the pay-off of an option can be calculated. These intrinsic values at exercise are then probability-weighted and discounted to their present value to estimate the fair value of the option at the grant date.
This narrative is part of the IFRS 2 series, look here.
Model selection
There are three main models used to value options:
- closed-form models: e.g. the BSM model;
- lattice models; and
- simulation models: e.g. Monte Carlo models.
These models generally result in very similar values if the same assumptions are used. However, certain models may be more restrictive than others – e.g. in terms of the different pay-offs that can be considered or assumptions that can be incorporated.
For example, a BSM model incorporates early exercise behaviour by using an expected term assumption that is shorter than the contractual life, whereas a lattice model or Monte Carlo model can incorporate more complex early exercise behaviour.
Simple model explanation
The approach followed in, for example, a lattice model illustrates the principles used in an option valuation model in a simplified manner.
Fundamental Principles of Value Creation – Companies create value by investing capital to generate future cash flows at rates of return that exceed their cost of capital. The faster they can grow and deploy more capital at attractive rates of return, the more value they create.