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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

Zentra plc is valuing an option to expand a project using the Black-Scholes model. Which input for the underlying asset is typically the hardest to observe directly and must usually be estimated from a comparable traded asset or from simulation?

The volatility of the project's cash-flow present value is the hardest input to observe. Real projects are not traded, so no price history exists. Volatility must be estimated from comparable listed companies or scenario simulation, whereas the risk-free rate, expiry and contractual exercise price are directly observable.

  1. AThe risk-free rate of interest
  2. BThe volatility of the present value of the project's cash flowsCorrect
  3. CThe time to expiry of the option
  4. DThe exercise price, where fixed by contract

Explanation

Risk-free rate, time to expiry and a contractual exercise price are observable or specified. The project has no traded price, so the volatility of its cash-flow value has to be estimated from proxies such as listed firms in the same business or from simulation.

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