Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

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Notethate−rtisthepresentvaluefactorandreflectsthefact
thattheexercisepriceonthecalloptiondoesnothavetobe
paid until expiration. N(d 1 ) and N(d 2 ) are probabilities
estimated by using a cumulative standardized normal
distribution and the values of d 1 and d 2 obtained for an
option. The cumulative distribution is shown inFigure A12.4.


FIGURE A12.4Cumulative Normal Distribution


In approximate terms, N(d 2 ) yields the likelihood that an
option will generate positive cash flows for its owner at
exercise(i.e.,whenS>Kinthecaseofacall optionand
whenK>Sinthecaseofaputoption).Theportfoliothat
replicatesthecalloptioniscreatedbybuyingN(d 1 )unitsof
theunderlyingassetandborrowingKe−rtN(d 2 ).Theportfolio
willhavethesamecashflowsasthecalloptionandthusthe
samevalueastheoption.N(d 1 ),whichisthenumberofunits

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