Seminar paper from the year 2002 in the subject Business economics - Investment and Finance, grade: 1 (A), Manchester Metropolitan University Business School (Corporate Finance), language: English, abstract: Options are a financial instrument with which one can reduce risk. Financial options are used by companies for this purpose and come in many forms, for example commodity, currency or interest rate options.
Options are also embedded in real investment decisions, for example in the form that a company gains the possibility (or option) to make a very profitable future investment (B), but only under the condition that the original investment (A) is made. This possibility increases uncertainty about the future, and has a value to the purchaser of the asset (A) at the time of purchase. Option pricing attempts to value this. This offers an alternative form of investment appraisal to the traditional Discounted Cash Flow (DCF) methods such as Net Present Value (NPV), that do not and can not account for and place a value on this uncertainty. There are two major methods of valuing options. One is the binomial method and the other is the Black & Scholes Formula. The options valued here all use the Binomial Model assuming European Options.