Real options

All you want to know about Real options

In corporate finance, real options analysis or ROA applies put option and call option valuation techniques to capital budgeting decisions.^[1] A real option itself, is the right - but not the obligation - to undertake some business decision; typically the option to make, or abandon, a capital investment. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real option.

ROA is often contrasted with more standard techniques of capital budgeting (such as NPV), where only the most likely or representative outcomes are modelled, and "flexibility" of this type is thus "ignored"; see Valuing flexibility under Corporate finance. ROA is therefore additionally useful in that it forces decision makers to be explicit about the assumptions underlying the projections, and is increasingly employed as a tool in business strategy formulation.

1 Considerations
2 History
3 Books
4 See also
5 References
6 External links

Considerations

In contrast to financial options, a real option is not often tradeable — e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision; however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive.

With real option analysis, uncertainty inherent in investment projects is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach). Cash flows can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate, using e.g. the cost of capital) or the cash flows (using certainty equivalents). These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment.

Generally, the most widely used valuation methods are: Closed form solutions, partial differential equations, and the binomial lattices.

History

The terminology "real option" is relatively new, whereas business operators have been making capital investment decisions for centuries. However, the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such, the terminology "real option" is closely tied to these new methods. The term "real option" was coined by Professor Stewart Myers at the MIT Sloan School of Management in 1977.

The concept of real options was popularized by Michael J. Mauboussin, the chief U.S. investment strategist for Credit Suisse First Boston and an adjunct professor of finance at the Columbia Business School. Mauboussin uses real options in part to explain the gap between how the stock market prices some businesses and the "intrinsic value" for those businesses as calculated by traditional financial analysis, specifically using discounted cash flows.

Real options are today an active field of academic research; one of the leading names in academic real options is Professor Lenos Trigeorgis (University of Cyprus). An academic conference on real options is organized yearly (Annual International Conference on Real Options).

In business strategy, real options have been advanced by the construction of option space, where volatility is compared with value-to-cost, NPVq. Latest advances in real option valuation are models that incorporate fuzzy logic and option valuation in fuzzy real option valuation models.

Books

Amram, Martha; Kulatilaka,Nalin (1999). Real Options: Managing Strategic Investment in an Uncertain World. Boston: Harvard Business School Press. ISBN 0-87584-845-1.
Copeland, Thomas E.; Vladimir Antikarov (2001). Real Options: A Practitioner's Guide. New York: Texere. ISBN 1-587-99028-8.
Dixit, A.; R. Pindyck (1994). Investment Under Uncertainty. Princeton: Princeton University Press. ISBN 0-691-03410-9.
Moore, William T. (2001). Real Options and Option-embedded Securities. New York: John Wiley & Sons. ISBN 0-471-21659-3.
Müller, Jürgen (2000). Real Option Valuation in Service Industries. Wiesbaden: Deutscher Universitäts-Verlag. ISBN 3-824-47138-8.
Smit, T.J.; Trigeorgis, Lenos (2004). Strategic Investment: Real Options and Games. Princeton: Princeton University Press. ISBN 0-691-01039-0.
Trigeorgis, Lenos (1996). Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge: The MIT Press. ISBN 0-262-20102-X.