Real Options
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Real options valuation is the term usually used for mathematical evaluation techniques inspired by the modeling of options on the financial markets. Several types of real options exists. Real options are considered to be closer to modeling financial reality by some when certain conditions apply. Most notably, whenever flexibility in decision making is possible, real options represent the financial reality more accurate than NPV. The most important difference with NPV is that a pure NPV calculation is not capable of modelling in the decision points that are present in reality. Practical examples of using real options include:
- Model the decision to expand production in at a later date.
- Model the decision to abandon after a first phase of development.
- Model phases to seperare technology and market risk.
There are different ways to calculate real options. The most common ways are:
| Option Type | Features | Option type used |
|---|---|---|
| Defer | IThe defer options enables postponing decisions until more information is available. | Call options |
| Stage | The investment is realized in several stages. After each stage, continuation or shutdown of the project can be considered. Returns are generally expected after the last stage | Call options on Call options |
| Explore | Investments start with a prototype / pilot version. If successful, real investments in project can begin. Unlike stage options, prototypes and pilots can generate payoffs | Call options on Call options |
| Expand | Option to increase future investments. | Call options |
| Contract | Opposite of expansion option. Cash Flow contraction can be modeled. Usually used to decrease variable costs. | Put options |
| Abandon / Switch | Option to model an exit from a project. Salvage values can be included to represent sell-off payoff from past investments. | Put options |
| Outsource | Models the decrease of cost due to sub-contracting. Often it possible to cancel the outsourcing contract with the payment of a penalty fee. | |
| Strategic Growth | IT investment results in possibilities to implement future investment opportunities otherwise not available. The underlying of the future investment can differ in underlying and volatility. Used to model infrastructure investments without own payoff | Call options |
| Compound | Option, which affects the value of other following options and vice-versa. | Call options on Call options |
mentions three important questions with respect to the relevance of real options:
- When is there a real option embedded in a decision or an asset?
- When does that real option have significant economic value?
- Can that value be estimated using an option pricing model?
See also:
