Financial Derivatives: Arundel Partners: The Sequel Project Boris Agababov Ekaterina Kouznetsova Alexander Nagornov Alexander Parkhomenko
Introduction of Arundel Sequel Project Innovative idea: purchase sequel rights for films produced by one or more major U. S. movie studios • • • Purchase sequel rights before the first films are even made Arundel does not make artistic judgments or select the rights for particular movies based on predictions for possible success Advance cash payments for the rights at a pre- agreed price to help finance production of the initial film
How does Arundel expect to benefit from the idea? • • Arundel can exercise the right when the performance of the first film is known. Expect revenue: 70% of the original movie If expected profitability is low or costs are too high to produce sequel Arundel can sell the right to the highest bidder. The loss a no moviegoer sequel will be: “price they sold the right – price they paid for the right” : loss will be deductible from tax. Arundel expects that gains from successful sequels will offset the losses
When does Arundel buy the rights? The sequel rights are purchased before production of first movie: • Purchase sequel rights for entire production of studio • Unknown which movies are going to be produced at the moment Arundel purchases sequel rights. • Price and number of movies should be agreed before either parties know which films are going to be produced. • Arundel don’t want to pay prices which reflects the opinion of the studio about the movie • Arundel pays the agreed price to an escrow account as soon the movie goes into production
How much are the sequel rights worth in 1989? Assumptions • • • We assume that the company buys sequel rights for the full sample portfolio (exhibit 6, a sample of 99 films) The option is exercised when present value of cash inflows is higher than USD 27, 7 mln (mean of the sample) If a sequel is produced, it is expected to generate 70% of the revenues of the original film. The negative cost of a sequel is expected to be 120% of the negative cost of original film Discount rate: 12% (Standard & Poor’s average for 1989)
How much are the sequel rights worth in 1989? Calculations Maximum price of the option should be such that Arundel generates 0 gain. Estimated price of an option – maximum USD 3, 6 mln
How much are the sequel rights worth in 1989? Sensitivity Analysis
Application of Black- Scholes Model • Call price • Parameters – – – S = current value of underlying = expected Revenue of a Sequel discounted to t=0 K = strike price = expected Cost of a Sequel (which has to be covered by revenue) T = time-to-maturity (in Periods) = standard deviation of S/S (S 0 = avg, S 1 = exp. revenue after first film) r = risk adjusted rate (here per Period) N(z) =cumulative standard normal probability density from - to z
Estimation of parameters for Black-Scholes
Estimation Results of Black-Scholes
Why Black-Scholes is not working? • • Markets are efficient Returns are normally distributed
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Nagornov_Arundel_case.ppt