An underlying asset has a current value of $100. Over the next interval

(a year), the value may change to either 150 or 20. The risk-free rate over

the interval is 5%.

(a) Value a call option on this asset assuming a strike price of 120.

(b) The option above actually represents a potential investment opportu-

nity for XYZ, Inc. XYZ is considering investing in some technology

(some ARM switches), which will give them the ability (after 1 year)

to decide whether to invest in an even newer, potentially more effi-

cient technology called ARMOUR switching; the payoffs above are

the relevant payoffs for ARMOUR. That is, the initial investment

required for ARMOUR is represented (in millions of dollars) by the

strike price of 120 in part a. Similarly, the potential payoffs in AR-

MOUR are represented by the 150 (million) (on the upside) and 20

(million) (on the downside). Clearly, this second investment is risky;

in fact, you have calculated its traditional NPV and it is negative.

You also know that the only way to obtain ARMOUR technology is

to first invest in ARM switches.

You believe that the ARMOUR switching technology has a great deal

of potential, but after calculating the traditional NPV of ARM (the

first investment required), youre discouraged by its negative NPV of

-10 million dollars.

Given the information you have about ARMOUR, your answer to

part a above and your intuition about option valuation, can you sell

ARM to your supervisor? How?

If new information comes in about ARMOUR which increases the

risk of its cash flows and reduces its NPV, would this change your

mind about its benefits? If so, how?