Posted in Finance, Accounting and Economics Terms, Total Reads: 452
Definition: Abandonment Option
An option is a contract which gives the buyer of an option a right but not an obligation to sell or buy foreign currency or any other underlying asset or instrument at a particular strike price, or on or before a specified date. An abandonment option is the option generally available in bilateral agreements where either one of the parties involved have the option to terminate the contract without fulfilling their contractual obligations. Abandonment option belongs to the class of American style option because it does not have a set time frame for expiry. In the field of finance, the style or family to which an option belongs largely depends upon the timeframe during which that particular option can be exercised.
European style options are the ones that can only be exercised at the end of the set timeframe while American style options are the ones that at any time before a specified date or expiration date.
Usually, American style options are more expensive because they give the holder more opportunity to exercise such option as compared to European styled options that can be exercised only at a pre-determined time.
These options are also known as “Vanilla Options”
In the field of corporate finance, abandonment option helps the buyer to sell the assets before the expiry date if the net present value (NPV) of the underlying asset falls below the amount which can be obtained after liquidation or below the amount actually invested.
NPV = INITIAL INVESTMENT – PRESENT VALUE OF FUTURE CASH FLOWS
Abandonment option is a type of ‘real option’ as well. Real options are generally related to project size or the timing of the project once it has been started. Real options are applicable to stock valuation as well. It basically helps the holder to retire the unprofitable ventures. This is basically equivalent to exercising a Put option. It is also known as ‘Termination Option”.