Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
 243

in the asset price. The opposite is true for a put option: the higher the asset price the less valuable is the
put option.

Exercise Price

An increase in a call option’s exercise price decreases the intrinsic value. The higher the exercise price for
American or European type options, the lower will be its premium. The opposite is true for a put option. The
higher the exercise price, the more valuable is a put option.

Risk-Free Interest Rate

Since buyers of options do not receive the option’s exercise price until later, interest rates play a role in the
determination of option value. A call option value increases with interest rates because the present value of
the strike price falls. A put option value falls with an increase in interest rates because the present value of
cash received decreases.

Volatility of Asset Price

An increase in the volatility of asset price increases the value of call option because of asymmetrical payoff
of options. That is, the upside is unlimited whereas the downside is limited to the premium paid. Although
the holder of a put option experiences limited potential gains, the holder can limit loss by simply not exercising
the option if the asset price rises above the exercise price. In sum, an increase in volatility leads to an
increase in the value of call and put options.

Time to Expiration

For both American and European type call options, an increase in the time to expiration has a positive impact
on the option value because the probability of the ending up in-the-money is more and the present value of
the exercise price is less. An American type put option also gains in value because of the chances of ending
up in-the-money. For European type options the impact of lengthening time to expiration is not known. If the
option is in-the-money, a longer time to maturity will have a negative impact because the present value of
cash receipt from exercising falls. If the option is deep out of the money, a longer time to maturity will
increase the option value because a longer time provides a greater opportunity for the stock price to drop far
enough to make the option valuable.