Question:

The chief executive officer (CEO) of Hibiscus Petroleum Bhd has just returned from a discussion at a leading university on the 'application of options to investment decisions and corporate value'. He wants to understand how some of the ideas which were discussed can be applied to decisions made at Hibiscus Petroleum Bhd. He is still a little unclear about some of the discussion on options and their application, and wants further clarification on the following:

1. Hibiscus Petroleum Bhd. is involved in the exploration and extraction of oil and gas. Recently there have been indications that there could be significant deposits of oil and gas just off the shores of Sarawak. The state government of Sarawak has invited companies to submit bids for the rights to commence the initial exploration of the area to assess the likelihood and amount of oil and gas deposits, with further extraction rights to follow. Hibiscus Petroleum Bhd is considering putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment assessment tool would be particularly useful to Hibiscus Petroleum Bhd in this respect.
2. The speaker further suggested that options were useful in determining the value of equity and default risk and suggested that this was why companies facing severe financial distress could still have a positive equity value.

Required:

1. Discuss the different features of options.
2. With regard to (i) above, discuss how Hibiscus Petroleum Bhd may use the idea of options to help with the investment decision in bidding for the exploration rights, and explain the assumptions made when using the idea of options in making investment decisions. 
3. With regard to (ii) above, discuss how options could be useful in determining the value of equity and default risk, and why companies facing severe financial distress still have positive equity values.

Introduction

One of the financial derivative securities, options are intrinsically connected with the price of another object. As a contract, options provide 'the right and not the obligation to purchase or sell an asset' at a predetermined price within a specific date (Bierman & Smidt 2003). The right to buy is termed as call option, whereas, the right to sell is terms as put option. 

Feature of Options

The main feature of options is that it does not obligate its owner to undertake any actions and offers only to the right to buy or sell an asset (Dejanovski 2014).  The major features of options are as follows.

i) Flexibility – There are two types of option contracts- standardized and privately arranged. Standardised option contracts are regulated and traded in organized exchanges. This option does not allow the writer (issuer) and users (holder) to make changes based on their requirements, thereby curbing flexibility. However, in the case of privately arranged option, these are traded 'over the counter'. These are updated based on the requirements of the issuer and holder.  This offers the holders the benefits of both futures and  forward contracts.

ii) Down Payment – In order to hold the right for an option, the holder has to pay a specific amount as premium. This is reflected as the consideration in the terms of the contract. In case, the option is not utilized, this premium amount would be foregone. Otherwise, this amount would be deducted from the payoff to be paid to the holder.

iii)Settlement – Unlike other contractual agreements, there is no transfer of assets or commodities or monetary resources when the options are written. The termination of the option contract occurs when the holder exercise the option or when it matures, whichever is earlier. This indicates that a settlement occurs only when the option holder exercises the option. If the option is not exercised up to its maturity, the settlement is not made as the agreement is deemed to be automatically lapsed.

iv) Non – Linearity: When compared to the futures and forward financial derivatives, options are not characterized by property of linearity. This condition of non-linearity arises that the profit that an option holder is entitled to do not hold a symmetrical relationship with the losses incurred from it. It means that the option holder's profit arising from the increase in asset value by a certain amount is not equal to the loss incurred due to the decline in the value of the asset by the same amount. For instance, an individual purchases a two-month call option for RM100 at RM3.35. If the dollar value appreciates within a time span of two months by RM0.05 per RM100, then the market price of the option would be RM3.40. In case of exercising this option, the option holder can purchase at RM3.35 and obtain a payoff of RM0.05 per Rm100. However, if the dollar value depreciated by RM0.05, then the market price would be RM3.30 and the option holder would not exercise this option. So there would be no loss. Thus, gain is not equivalent to loss in an option contract.

v) Not Obligated to Buy or Sell: According to the option contracts, the option holder is vested with the right to buy or sell an underlying asset. The option holder has the ability to exercise this right at any instance within the maturity period of the options. However, the option holder is not obligated to buy or sell the asset. If there is no buying or sales within the maturity period, then the contract is deemed lapsed.

(Some parts of the solution has been blurred due to privacy protection policy)