Real options theory and practice northwestern university. Section three presen ts our main econometric results, and the nal section concludes. Understanding how option pricing works and the components that determine an option price. A real option is a choice made available with business investment opportunities, referred to as real because it typically references a tangible asset instead of financial. Therefore, this paper analyzes the application of option pricing models to the valuation of it investments. A generalized binomial model with applications to real options abstract we extend a popular binomial model to allow for option pricing using realworld rather than riskneutral world probabilities. We do not spend much time on the technicalities of option pricing, though we present some of the special issues that come up when valuing real options. Blackscholes and beyond, option pricing models, chriss 6. Real option analysis example 3 a company is considering investing in a project. A prospect theory based real option analogy for evaluating flexible systems and architectures in naval ship design by joshua knight chair.
Chapter 5 option pricing theory and models in general, the value of any asset is the present value of the expected cash flows on that asset. Lectures on real options part i august, 2008 18 44. Following this description of the real options approach, the first question to be asked when a firm considers an investment opportunity is. The capital asset pricing model and the arbitrage pricing. Examining the standard coefficients of the economic variables, the option based pricing models identify the role of uncertainty in land price variations. Thus, real options analysis usually implies that investment should be delayed, compared with traditional dcf analysis. It explains the production, allocation, consumption and pricing of goods and services. A generalized binomial model with applications to real options, dept of finance. Aug 31, 20 the application of real options theory is generally accompanied by a monetary valuation of real options through option pricing models which in turn are based on restrictive assumptions and thus subject to criticism. The real options method represents the new stateoftheart technique for the valuation and management of strategic investments.
Real options, real options analysis, investment, investment analysis, developing countries. Some real options are complex and their exercise creates other options. Valuation of it investments using real options theory. Flexibility and information have real and sometimes substantial value. Trees to solve realoption valuation problems, decision analysis, v2, 6988. Stochastic processes and the mathematics of finance. Rov theory applies option pricing theory more broadly than does the typical application of finan cial option valuation i. The blackscholesmerton theory for pricing and hedging options has played a fundamental role in.
This paper expands the theory of real options to enhance the practical usability of the method via a conceptual framework. While option pricing models are indeed a superior valuation tool the purpose to which the theory is generally put we believe real options can provide a systematic framework that will also serve as a strategic tool, and that it is in this strategic application that the real power of real options. The paper concludes with reasons for the likely success of real options as an investment analysis method and notes the potential positive effects implementing the approach will have in the construction industry in developing countries. At that time, fischer black and our best thanks go to william sharpe, who first suggested to us the advantages of the discretetime approach to option prlcmg developed here. The underlying asset may not be traded, which makes it difficult to estimate value and variance for teh underlying asset. Applies to strategic, as well as financial options. The value of a call option in the blackscholes model can be written as a function of. Real options, risk adjusted value and probabilistic assessments before we embark on a discussion of the options to delay, expand and abandon, it. There are many applications in corporate finance where the financial option valuation models are applied on the real assets valuation real options approach. The most commonly used models today are the blackscholes model and the binomial model. A laypersons guide to the option pricing model everything you wanted to know, but were afraid to ask by travis w.
In this section, we will consider an exception to that rule when we will look at assets with two specific characteristics. While specialists have grown accustomed to working with the tool and have faith in the results of its. Trigeorgis 1993 3 divided the real options into seven categories according to the differences in flexibility. Pdf options pricing by monte carlo simulation, binomial. They derive their value from the values of other assets. Options slides pdf video for part i of options covers slides 14. An financial option is a right, but not an obligation, to make an investment decision. Payoff diagram for a put option as shown in figure 12, the net payoff of a put option remains negative and equivalent to the put price price paid to buy the option, as long as the under. This video lecture continues to cover option pricing by deriving a generalized binomial model, and the implications of the conditions under which the formula holds. Real options analysis tools and techniques for valuing strategic. Some researchers use real options combined with game theory to analyze. A real option itself, is the rightbut not the obligationto undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. The implementation of real options theory for economic. Real options theory is a major new framework in the theory of investment decisionmaking.
The use of real options approach in energy sector investments. Option to defer, staged investment option, option to alter operating scale, option to abandon, option to. A prospect theorybased real option analogy for evaluating. Scholes theory to american options, showing that optimal exercise of the option occurs when the asset price exceeds or falls below an exercise boundary for a call or put option. Harms, cfa, cpaabv the option pricing model, or opm, is one of the shiniest new tools in the valuation specialists toolkit.
The present value pv of future discounted expected cash flows is either 10,000 if the market goes up or 5,000 if the market goes down next year. Real options theory assumes that firms also have some choice in when to invest. Birge northwestern university informs practice meeting, montreal, may 2002 outline planning questions problems with traditional analyses. This paper begins with a short introduction to options, the determinants of option value and the basics of option pricing. The second part sheds light on the potential relationship of strategic. With uncertainty and irreversibility, npv rule is often wrong very wrong. Waitingtoinvest option, growth option, flexibility option, exit option and learning option. Options video lectures and slides finance theory i. While optionpricing models are indeed a superior valuation tool the purpose to which the theory is generally put we believe real options can provide a systematic framework that will also serve as a strategic tool, and that it is in this strategic application that the real power of real options lies. Monte carlo methods are used in corporate finance and mathematical finance to value and analyze complex instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining the distribution of their value over the range of resultant outcomes. The value of equity, obtained from a discounted cash flow valuation model, does not measure the option to control, and if necessary, liquidate the firm that equity. A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. To a better understanding of the real options theory, it.
The economic analysis of real option value willamette. Real options, property development, discounted cash flow, managerial flexibility, uncertainty 1. Pindyck massachusetts institute of technology cambridge, ma 02142. Pricing electricity forwards using the real option theory. Some of the investment opportunities companies are faced with are the construction of a factory, installing equipment or expanding. Real options analysis and strategic decision making edward h. We introduce the framework for real options and examine the di. Uncertainty, or corrections for risk make asset pricing interesting and challenging. Cox school of business, southern methodist university, p.
Riskneutral valuation understanding risk neutral valuation 25 the states model and risk neutral valuation risk neutral valuation is a very important concept in option pricing in fact it is nothing more than a simple redefinition of the variables in our basic pricing relation using ad. Application of option pricing theory in investment decisions. The promise and peril of real options new york university. However, the theory of the firm traditionally argues into a similar direction by viewing the firm as either a set of institutions, as set of property rights or as a set of contracts. This is usually done by help of stochastic asset models. Combining financial mathematics with statistical modeling ling chen securities division, goldman sachs tze leung lai department of statistics, stanford university tiong wee lim department of statistics and applied probability, national university of singapore keywords option pricing, substantive models. Kim and sanders expand a framework of strategic actions relied on real option theory. Chapter 27 the real options model of land value and. Since it is an offer to sell the project as an abandonment option, a put option value is calculated based on the finance directors assessment of the standard deviation and using the blackscholes option pricing bsop model, together with the putcall parity formula. Real options methodology represents an approach where financial options pricing theory and models are applied on real assets valuation. Bowman deceased formerly at the wharton school, university of pennsylvania gary t. They use the riskneutral probabilities from the option pricing model in the. The price of the asset may not follow a continuous process, which makes it difficult to apply option pricing models like the black scholes that use this assumption.
A prospect theory based real option analogy for evaluating flexible systems and architectures in naval ship design by joshua t. The results favor the application of the real option theory in land prices. The theory behind this new method, called real option analysis, is the valuation of financial options in a riskneutral world. Can value important real options, such as value of land. Navy design and acquisition programs has been the emphasis on exible systems and architectures. Option theory can help identify and measure options embedded in real assets.
Real options methodology and flexibility valuation. It is related to real time scenarios, but it is not real time probability. The basic mission of option pricing theory is to calculate the probability that an option will expire in the money. Real options and the theory of the firm abstract from the real options perspective the firm is conceived as a portfolio of real options. Introduction to option pricing liuren wu zicklin school of business, baruch college. Furthermore, we exhibit the practical relevance and assumptions of these models. Leftwich, is concerned with the flow of goods and services from business firms. Chapter 27 the real options model of land value and development project valuation major references include. Can value important real options, such as value of. A generalized binomial model with applications to real options abstract we extend a popular binomial model to allow for option pricing using real world rather than riskneutral world probabilities. The real options model of land value and development project valuation major references include.
This is why this paper starts by presenting basic pricing concepts. Any model or theory based approach for calculating the fair value of an option. Real options valuation with changing volatility sciencedirect. First, our model allows direct inference about relevant. Real options valuation, also often termed real options analysis, rov or roa applies option valuation techniques to capital budgeting decisions. Since the intention is to hedge away risk under all scenarios and discount back with riskfree rate, we do not really care about the actual probability of each scenario happening. In a pod project, real options are used in the decisionmaking process for managing risk and opportunities which are the source of uncertainties. Real options analysis and strategic decision making author. The discounted cash flow method does not always completely capture the uncertainty of. Real options are not just about getting a number, they also provide a useful framework for strategic decision making.
Combination of real options and gametheoretic approach in. While optionpricing models are indeed a superior valuation tool the purpose to which the theory is generally put we believe real options can provide a. The real options theory in petroleum industry was first introduced by paddock, siegel and smith in 1987 in the format of option pricing. Price theory, also known as microeconomics, is concerned with the economic behaviour or individual consumers, producers, and resource owners. European option pricing with transaction costs 473 where. The first part of my study details the most important results of real option financial valuation. To do this, the blackscholes model looks beyond the simple fact that the value of a call option increases when the underlying stock price increases or when the exercise price decreases. Modularity and designforupgradability are two examples of this trend. Option pricing theory has a long and illustrious history, but it also underwent a revolutionary change in 1973. Potential applications of real option analysis in the. The discrete binomial model for option pricing rebecca stockbridge program in applied mathematics university of arizona may 14, 2008 abstract this paper introduces the notion of option pricing in the context of. Further, there exist large quantities of data for testing the option pricing theory. Give the opportunity to make a decision after you see.
Robert pindyck mit lectures on real options part i august, 2008 18 44. Price is a major parameter that affects company revenue significantly. Empirical testing of real optionpricing models using land. In exploring their reservations about real option analysis as a valuation methodology, we have come to the conclusion that much of the problem lies in the. The long history of the theory of option pricing began in 1900 when the french mathematician louis bachelier deduced an option pricing formula based on the assumption that stock prices follow a. Knight a dissertation submitted in partial ful llment of the requirements for the degree of. We then looks at option applications in three parts. It is precisely the way in which real options deal with uncertainty and flexibility that generates their value.
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