Real options analysis

In corporate finance, real options analysis or ROA applies put option and call option valuation techniques to capital budgeting decisions. [Campbell, R. Harvey. [http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm "Identifying real options" ] , Duke University, 2002.] 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.

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

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

ee also

*Option
*Black-Scholes
*Financial modeling

References

External links

* [http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm Identifying real options] , Prof. Campbell, R. Harvey. Duke University
* [http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/opt.html Applications of option pricing theory to equity valuation] Prof. Aswath Damodaran, Stern School of Business
* [http://www.expectationsinvesting.com/tutorial11.shtml How Do You Assess The Value of A Company's "Real Options"?] , Prof. Alfred Rappaport Columbia University and Michael Mauboussin
* [http://www.puc-rio.br/marco.ind/tutorial.html Real Options Tutorial] , Prof. Marco Dias, PUC-Rio
* [http://sphere.rdc.puc-rio.br/marco.ind/ro-links.html Real Options Selected Links] , Prof. Marco Dias, PUC-Rio
* [http://moneyscience.org/home/tiki-read_article.php?articleId=5 Real Options Links and Resources at MoneyScience]
* [http://lean.mit.edu/index.php?option=com_docman&task=cat_view&gid=333&dir=DESC&order=date&Itemid=99999999&limit=8&limitstart=8 Strategic Technology Investment Decisions in Research & Development] David Lackner MIT Lean Advancement Initiative
* [http://www.financialmodelingguide.com/analytical-tools/real-options/ Real Options in Financial Modeling]


Wikimedia Foundation. 2010.

Look at other dictionaries:

  • Real Options Analysis — involves applying the mathematical techniques found in financial options to assess the best course of action to be taken when faced with a real life decision. For example, R D managers can use Real Options Analysis to help them determine where to …   Wikipedia

  • Real options valuation — Real options valuation, also often termed Real options analysis,[1] (ROV or ROA) applies option valuation techniques to capital budgeting decisions.[2] A real option itself, is the right but not the obligation to undertake some business decision; …   Wikipedia

  • Real Options Group — The Real Options Group (ROG) is a management consulting firm specializing in the application of Real Options Analysis. The President of ROG is Dr. Lenos Trigeorgis, a pioneer in the field. Supporting ROG are both an academic and corporate… …   Wikipedia

  • Real estate broker — This article is about the North American practice. For other definitions and practices in other countries, see Real estate. For real property, see Real property. Realtor redirects here. For the real estate industry trade association that refers… …   Wikipedia

  • Binomial options pricing model — BOPM redirects here; for other uses see BOPM (disambiguation). In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. The binomial model was first proposed by Cox, Ross and… …   Wikipedia

  • Credit spread (options) — Finance Financial markets Bond market …   Wikipedia

  • Graduate real estate education — MSRE redirects here. MSRE may also refer to the Molten Salt Reactor Experiment. The study of real estate and real estate development at the graduate school level has taken many forms, giving rise to various educational models in the United States …   Wikipedia

  • Technical analysis software — automates the charting, analysis and reporting functions that support technical analysts in their review and prediction of financial markets (eg. the stock market). Description of Technical Analysis Software FeaturesThe following are descriptions …   Wikipedia

  • Technical analysis — Financial markets Public market Exchange Securities Bond market Fixed income Corporate bond Government bond Municipal bond …   Wikipedia

  • Network analysis (electrical circuits) — Linear Network Analysis Elements …   Wikipedia

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”

We are using cookies for the best presentation of our site. Continuing to use this site, you agree with this.