Real Options Pricing and Hedging-Finance Assignment Sample

QUESTION

ANSWER

Usually the department of Fleet Development and Aircraft trading in a airline company is responsible for the procurement, financing and the sale of aircraft. Procurement of aircraft by an airline company is a capital budgeting decision, that is taken by the management of the company with a view to earn positive return for the company. The same question arises in the situation when the aircraft is required to be replaced by the company. How many aircrafts is required by the company, what are the new routes required by the company, should company buy the new planes or lease them from the aircraft manufacturing company, what is the appropriate fleet size. These are few of the many question that arises for the decision-making process in an airline company.

But the biggest question that arises while buying an aircraft is that how to finance the aircraft. The airline company have the option of either buying the aircraft or leasing them. This choice depends on the advantage and disadvantages of the two option to the firm planning to buy the aircraft.

Buying gives us two choices either going for the full financial lease or no financing which also means full payment upfront to the aircraft manufacturing company. Full financial lease can be obtained from a bank willing to finance the aircraft and pay up the full amount to the manufacturing company upfront. The problem with buying is that, in the case of upfront payment it put pressure on the liquidity of the company as these companies require huge amount of fund to run the day to day operations of the company, with financial leasing it impacts the gearing ratio of the company and puts the pressure for regular lease and interest payments. The overall problem with buying the aircraft is that you became the owner of the craft which as compared to leasing in which the aircraft after its use is ultimately returned to the manufacturer at the end of the lease term. Therefore, in case of buying the aircraft the company always faces the uncertainty relating to the residual value of the aircraft and thus a potential risk.

Leasing mainly consist of two options, both of which are more or less similar. In the first option the airline company can directly go to the lessor and lease the aircraft. This type of lease is called operational lease or direct lease. The other possible way is that, the airline company is first required to buy the aircraft and immediately has to sale back the aircraft to the lessor with an agreement that the lessor will lease the aircraft back to the airline company. These types of lease are called sale and lease back construction of lease. The advantage of this type of method to the airline company is that the company can customize the aircraft for its requirement. Also, when an airline company requires an aircraft for shorter duration these types of lease are best suited for such type requirements.

But the financing decision does not end here, it is actually much more complicated than what we talked above. There are generally options involved with these decisions. And the most common option that is associated in the airline industry is the option to buy additional aircraft from the same aircraft manufacturer over the life of the original aircraft purchased. This option generally works in the following manner, an airline company can lock the price of the future purchase of the aircraft while buying the first aircraft. Over a course of, say, 1 to 2 years the airline company can exercise the option of buying the aircraft at the predetermined price.

This is not the only option available to the airline company. There are other option available such as extension of lease period by say 2 years and others such as the aircraft can be bought back at the price decided at the start of the lease period

Therefore, these financing decisions are very important from the profitability of the airline company. As we know, a capital budgeting decision is evaluated on the basis of the Net Present Value. But these types of cases carry a certain type of uncertainty. These uncertainties along with the options that are present with these types of decision require a different kind method for the purpose of evaluation. These types of options are called real option. Real options combine the inherent uncertainty that is present in the business these days with the managerial flexibility, that a company usually adopt appropriate strategies that are being presented to them time to time. Alternatively, real options are useful to the companies that are continuously changing or updating their business strategies such as to drop a project, start a new project, restart an old one, temporally pause an existing one in response to the changing environment and circumstances. Such managerial flexibility allows the manager not only to minimize the risk and reduce the losses but also to capture any profit potential that is now available due to changing circumstances. In short real option provides more appropriate valuation as compared to the Discounted Cash Flow techniques.

Determining the basics of Real Options

σ =

22.00%

r =

2.00%

u =

1.056541

d =

0.946485

p =

0.577573

I =

290

1-p =

0.422427

DF =

1.01005

Binomial Tree for Price that is determined using the above given information

S1

S2

       

2.3675

 

2.2408

 
 

2.1209

2.1209

 

2.0074

2.0074

 

1.9000

1.9000

1.9000

 

1.7983

1.7983

 
 

1.7021

1.7021

 

1.6110

 
       

1.5248

The above prices of the jet fuel have been derived after taking into the account the amount of uncertainty that is prevalent in the market.

From the above prices we can derive the earnings and resale value of the aircraft at different nodes, Using the following equation

 

const.

S

S^2

P1

305

-5

0

P2

290

-4

0

M1

57

-50

10

M2

100

-30

-2

The Resale value of the aircraft at each node is

P1

P2

 

280.5298

   

294.3954

281.5163

   

295.5000

282.4000

   

296.4896

283.1917

   
 

283.9009

And the earning during the two years is

M1

M2

 

17.7631

   

-4.0630

27.3755

   

-1.9000

35.7800

   

0.8667

43.1433

   
 

49.6065

The value of the option is

V0

 

V1

 

V2

       

298.2929

     

299.7575

 
   

296.8712

 

308.8918

 

298.7259

 

309.7028

 

300.4200

 

308.3689

 

318.1800

 

309.8838

 

318.4246

 
   

319.3278

 

326.3349

     

326.0875

 
       

333.5073

Please note that there is no liquation taking place at any node.

The NPV of the project comes out to be $10.40

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