Real option - Wikipedia, the free encyclopedia http://en.wikipedia.

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Real option
From Wikipedia, the free encyclopedia.

A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a
capital investment. For example the opportunity to invest in the expansion of a firm's factory is a real option. In contrast to
financial options a real option is not tradeable - e.g. the factory owner cannot sell the right to extend his factory to another
party, only he has the decision to make. 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.

Certain critical components of real options make them a powerful analytical tool. First, they recognize and value the
flexibility that today's capital investments provide. Second, they recognize the staged nature of many investments and
account explicitly for the reality that certain investments will never be made if -- based on additional information
developed over time--they are deemed unattractive. In these instances, it makes sense simply to abandon them, rather than
sink additional monies into a poor investment. By contrast, DCF (Discounted Cash Flow) evaluates a series of
investments as if they will be made, regardless of whether they still make sense at a later date.

Additionally, 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. More
importantly, the real options approach forces decision makers to be more explicit about the assumptions underlying their
projections.

Another critical difference between DCF and real options is the effect of uncertainty (or risk) on value. Uncertainty is
typically considered bad for the valuation of traditional cash flows. By contrast, uncertainty increases the value of real
options.

Real options are not universally recognized as a means of valuing capital investments. Yet, the now ubiquitous capital
asset pricing model did not become a common pricing model overnight, either. Consider the following key points:

As volatility (uncertainty) increases, so does the value of the real option.

Initiatives with great uncertainty should be implemented in stages. Making a small investment up front can give
management the ability to resolve uncertainty through data gathering and learning. The larger investment can be made in a
future environment with less uncertainty.

A series of initiatives should be looked at on a portfolio basis. The overall results of the investment portfolio are what
ultimately matters, not the individual performance of each initiative.

Real options recognize that abandonment is a viable alternative that must be contemplated from the outset. Furthermore,
dropping a project does not necessarily mean that the team in charge of the particular initiative has failed.

Technology investments might often grant the possibility of pursuing an avenue in several months or a couple of years.
But without the relatively small initial investment, an opportunity might be foreclosed forever. Although real options can
be intuitively appealing, execution to arrive at a value is difficult. Determining the exact value of a real option is not
necessarily critical. Instead, understanding the drivers of the valuation and the value relative to traditional methods is
much more important.

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Real option - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Real_option

external links
Identifying real options
(http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm ) Prof. Campbell R.
Harvey, Fuqua School of Business
Applications of option pricing theory to equity valuation
(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/opt.html) Prof. Aswath Damodaran, Stern
School of Business
An extensive list of links to articles, papers and information
(http://www.moneyscience.org/tiki/tiki-read_article.php?articleId=38) at moneyscience.org
An introduction to real options
(http://www.finance24.com/register/help/mmx_school/displayarticlewide.asp?ArticleID=328942) (PDF), The
Investment Analysts Society of South Africa
Applying Options Theories to Technology Management Decisions
(http://www.ctonet.org/documents/OptionsTheories_TechMgt.pdf) , CTO Network Library, 2005.

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Categories: Derivatives

This page was last modified 06:38, 17 August 2005.

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