“To factor real-world uncertainties into your decisions,
look beyond net present value”
-Dixit and Pindyck
4.1 Introduction
An option is a security giving the right to buy or sell an asset, subject to certain conditions, within a specified period of time. An “American option is one that can be exercised at any time up to the date the option expires. A “European option” is one that can be exercised only on a specified future date. (Black and Scholes, 1973) The holder of the contract has the possibility of payoff from an underlying security or asset, without initially owning/buying the underlying security or asset. The contract specifies the exercise price. The exercise price is the price the holder of a call option must pay for the underlying security if he chooses to exercise the option. If the exercise price is lower than the market value of the underlying security, the option gives a positive payoff and the option is said to be “in the money”. If the exercise price is higher than the market value of the underlying security, the option does not give a positive payoff and the option is said to be “out of the money”. An investor would not exercise a call option if he could buy the security in the market at a lower price. In contrast, if the call option gives the holder the right to buy the security cheaper than he could do in the market, he would do so and achieve a positive payoff. If X is the exercise price, and St the stock price at the
expiration date, the payoff structure for a European call option is:
(7) max(StX,0)
Financial options on stocks, stock indexes, bonds, foreign exchange and commodities are extensively traded, and represent important tools for investors with regards to speculation and hedging. The most popular valuation method of financial options is the Black-Scholes formula. This method was introduced by Fischer Black and Myron Scholes in their 1973 article “The Pricing of Options and Corporate Liabilities”. A further application of the thoughts and insights by Black and Scholes was developed by Stewart Myers. In his 1977 article “Determinants of Capital Borrowing” he was the first to use the term “real options”, identifying that many corporate real assets can be viewed as call options (Bratvold, Laughton, Enloe and Begg, 2005).
The idea of the real option approach is to use techniques used to value financial options to value real projects where management can exercise options on different strategic directions throughout the lifetime of projects. The main types of real options include the option to delay, abandon, expand and decrease investments in projects. Investment profiles of projects can often be characterized as sequential, giving companies time to learn about the project and market conditions as time goes by. The knowledge acquired may give rise to new possibilities increasing the value of projects, or giving companies the chance to stop projects moving in wrong directions.
There are some important differences between real options and financial options. First of all, investment projects are normally not traded securities as compared to financial options. Given that markets of financial options work like they should, the correct market value of financial options are set by various buyers and sellers operating in the market. Real options are not traded securities, resulting in more uncertainty in terms of valuation.
Secondly, real options are often more complicated than financial options. Financial options often depend on only one underlying variable, for instance the value of a stock. The value of real options is often determined by more than one underlying variable. Due to this, the value of projects is often not known at the time investment decisions are made (Laine, 1997).
Third, real options normally have longer time to expiration compared to financial options. This is caused by the already mentioned issue of projects having long time horizons. Projects with long time horizons often have different real options attached that can be exercised throughout the lifetime of projects.
Fourth, private uncertainty often plays a bigger role in real options compared to financial options. Issues like technology, extractable reserves, capex and opex can be considered as private uncertainty, and have a big potential in affecting the value of real options. Another difference involves the decision rule being more important in real options than in financial options. Decisions about exercising real options normally have bigger consequences than decisions about exercising financial options. As an example, the option to expand a project may lead to high investments and confiscation of a company’s resources.
The real option approach is usually regarded appropriate when investments are recognized by a great deal of uncertainty regarding the actual value of projects, and when companies can learn more about the value of projects as time goes by and uncertainties are resolved. Further on, companies and projects need to have sufficiently flexibility to adapt to new information and knowledge. (Smith and Mccardle, 1998) Examples of projects with these characteristics include investments in R&D, flexible production systems and oil field licenses containing possible profitable petroleum reserves. According to Laughton et al (2000), the future role of the real option approach is not clear, and much fundamental work still remains in developing the approach. They point to the fact that The Economist reported that 46% of a sample of companies that experimented with real options had abandoned their experiments. There has been much academic research on the application of real options. In theory, the approach seems logic and appropriate. In real life there seem to be several practical issues that need to be solved before real options can be used for project valuation. The following sections explain valuation of financial options and valuation of real options.