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<h2 class="hd hd-2 unit-title">Origins of Option Pricing Theory</h2>
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<h3 class="hd hd-2">Origins of Option Pricing Theory</h3>
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<h2 class="hd hd-2 unit-title">What is an Option?</h2>
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<h2 class="hd hd-2 unit-title">Exercise: What is an Option?</h2>
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Exercise: What is an Option?
</h3>
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<p>Imagine you are the CFO of ABC Pharmaceuticals, and you have just financed a Phase 3 clinical trial for a new migraine medication at a cost of $200 million. If the trial is successful, the market launch for the new therapy would cost $100 million, and would occur at the end of the clinical trial in 3 years.</p>
<ol>
<li>If we think of the possibility of launching the new therapy as an option, is it a call or a put?
<p><div class="wrapper-problem-response" tabindex="-1" aria-label="Question 1" role="group"><div class="choicegroup capa_inputtype" id="inputtype_8d02326ee5204b0087c34a539ff7f5e4_2_1">
<fieldset aria-describedby="status_8d02326ee5204b0087c34a539ff7f5e4_2_1">
<div class="field">
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</label>
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<div class="field">
<input type="radio" name="input_8d02326ee5204b0087c34a539ff7f5e4_2_1" id="input_8d02326ee5204b0087c34a539ff7f5e4_2_1_choice_4" class="field-input input-radio" value="choice_4"/><label id="8d02326ee5204b0087c34a539ff7f5e4_2_1-choice_4-label" for="input_8d02326ee5204b0087c34a539ff7f5e4_2_1_choice_4" class="response-label field-label label-inline" aria-describedby="status_8d02326ee5204b0087c34a539ff7f5e4_2_1"> <text>Put option</text>
</label>
</div>
<span id="answer_8d02326ee5204b0087c34a539ff7f5e4_2_1"/>
</fieldset>
<div class="indicator-container">
<span class="status unanswered" id="status_8d02326ee5204b0087c34a539ff7f5e4_2_1" data-tooltip="Not yet answered.">
<span class="sr">unanswered</span><span class="status-icon" aria-hidden="true"/>
</span>
</div>
</div></div></p></li>
<li>
What is its strike price? (<i>Note</i>: Your answer should be expressed in units of millions of dollars.)
<p><p style="display:inline">$</p><div class="inline" tabindex="-1" aria-label="Question 2" role="group"><div id="inputtype_8d02326ee5204b0087c34a539ff7f5e4_3_1" class=" capa_inputtype inline textline">
<div class="unanswered inline">
<input type="text" name="input_8d02326ee5204b0087c34a539ff7f5e4_3_1" id="input_8d02326ee5204b0087c34a539ff7f5e4_3_1" aria-describedby="status_8d02326ee5204b0087c34a539ff7f5e4_3_1" value=""/>
<span class="trailing_text" id="trailing_text_8d02326ee5204b0087c34a539ff7f5e4_3_1"/>
<span class="status unanswered" id="status_8d02326ee5204b0087c34a539ff7f5e4_3_1" data-tooltip="Not yet answered.">
<span class="sr">unanswered</span><span class="status-icon" aria-hidden="true"/>
</span>
<p id="answer_8d02326ee5204b0087c34a539ff7f5e4_3_1" class="answer"/>
</div>
</div></div><p style="display:inline">million</p></p>
</li>
<li>
What is its time to maturity?
<p><div class="inline" tabindex="-1" aria-label="Question 3" role="group"><div id="inputtype_8d02326ee5204b0087c34a539ff7f5e4_4_1" class=" capa_inputtype inline textline">
<div class="unanswered inline">
<input type="text" name="input_8d02326ee5204b0087c34a539ff7f5e4_4_1" id="input_8d02326ee5204b0087c34a539ff7f5e4_4_1" aria-describedby="status_8d02326ee5204b0087c34a539ff7f5e4_4_1" value=""/>
<span class="trailing_text" id="trailing_text_8d02326ee5204b0087c34a539ff7f5e4_4_1"/>
<span class="status unanswered" id="status_8d02326ee5204b0087c34a539ff7f5e4_4_1" data-tooltip="Not yet answered.">
<span class="sr">unanswered</span><span class="status-icon" aria-hidden="true"/>
</span>
<p id="answer_8d02326ee5204b0087c34a539ff7f5e4_4_1" class="answer"/>
</div>
</div></div><p style="display:inline">years</p></p>
</li>
</ol>
<div class="solution-span">
<span id="solution_8d02326ee5204b0087c34a539ff7f5e4_solution_1"/>
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<h2 class="hd hd-2 unit-title">Exercise: Valuation of Options</h2>
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Exercise: Valuation of Options
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<p>Imagine you are the CFO of ABC Pharmaceuticals, and you have just financed a Phase 3 clinical trial for a new migraine medication at a cost of $200 million. If the trial is successful, the market launch for the new therapy would cost $100 million, and would occur at the end of the clinical trial in 3 years. In addition, depending on economic market conditions, the present value of future commercialization profits could either go up 50% to $750 million or down 50% to $250 million. The 3-year annualized risk-free rate is 4% per year.
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<li>Ignoring the scientific risk associated with the trial (which is assumed to be independent of the market risk), what is the value of the project? (Note: Your answer should be expressed in units of millions of dollars.)
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<li>Now suppose the probability of success of the trial, due to scientific risk, is 60%. What is the rNPV of the project? Assume the project has no value if it fails. (Note: Your answer should be expressed in units of millions of dollars.)
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<h2 class="hd hd-2 unit-title">Interactive: Black-Scholes Formula</h2>
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<p>The graph below calculates the price of a call option using the Black-Scholes formula. What happens to the option's price if you change the volatility of the underlying stock? What happens if you change the option's maturity or strike price? </p>
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