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 (S0 = avg, S1 = 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 Thank you for your attention!