Real Options Illustrated

by Linda Peters

Real Options Illustrated This book explains the standard Real Options Analysis ROA literature in a straightforward step by step manner without the use of complex mathematics A lot of ROA literature is described through partial differential equations probability density functions and simulation techniques all of which may be unconvincing in the applicable qualities ROA possesses Using this book the reader will have a better grasp about how ROA works and will be able to provide his or her judgment about ROA since

Publisher : Springer International Publishing

Author : Linda Peters

ISBN : 9783319283098

Year : 2016

Language: en

File Size : 2.88 MB

Category : Science Math

SPRINGER BRIEFS IN FINANCE

Linda Peters

Real Options
Illustrated

123

SpringerBriefs in Finance

More information about this series at http://www.springer.com/series/10282

Linda Peters

Real Options Illustrated

Linda Peters
Applied Economics
University of Antwerp
Antwerp, Belgium

ISSN 2193-1720
ISSN 2193-1739 (electronic)
SpringerBriefs in Finance
ISBN 978-3-319-28309-8
ISBN 978-3-319-28310-4 (eBook)
DOI 10.1007/978-3-319-28310-4
Library of Congress Control Number: 2016931340
© Springer International Publishing Switzerland 2016
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Contents

Introduction to Real Options Analysis . . . . . . . . . . . . . . . . . . . . . .
1.1 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1.1 Basics of Option Theory . . . . . . . . . . . . . . . . . . . . . . . .
1.1.2 From Financial Options to Real Options . . . . . . . . . . . . .
1.1.3 Common Real Options . . . . . . . . . . . . . . . . . . . . . . . . .
1.2 A Simple Real Options Analysis Example . . . . . . . . . . . . . . . . .
1.3 Key Strengths of Real Options Analysis . . . . . . . . . . . . . . . . . .
1.4 Weaknesses of Real Options Analysis . . . . . . . . . . . . . . . . . . . .
1.5 Three Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.1 Analytical Versus Numerical . . . . . . . . . . . . . . . . . . . . .
1.5.2 Dynamic Programming . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.3 Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.4 Comparing Dynamic Programming and Contingent
Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.5 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Comparison of Real Options Analysis and Other Methods . . . . . . .
2.1 The Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Net Present Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3 Decision Tree Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.4 Real Options Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.4.1 Replicating Portfolio Approach . . . . . . . . . . . . . . . . . . .
2.4.2 Risk-Neutral Probability Approach . . . . . . . . . . . . . . . . .
2.5 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Real Options Methods Illustrated . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1 Netscape: Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.1 The Valuation Formula . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.2 The Main Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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vi

Contents

3.1.3 The Case: Netscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1.4 Strengths and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . .
3.2 Option Pricing: Cox, Ross and Rubinstein . . . . . . . . . . . . . . . . . .
3.2.1 The Basic Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.2 The Binomial Option Pricing Formula . . . . . . . . . . . . . . .
3.2.3 The Main Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.4 Strengths and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . .
3.2.5 The Binomial Tree Method Illustrated . . . . . . . . . . . . . . .
3.3 The Portes Case: Copeland and Antikarov . . . . . . . . . . . . . . . . . .
3.3.1 The Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.2 The Main Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.3 The Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.4 Strengths and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . .
3.4 The Boeing Approach: Datar Mathews . . . . . . . . . . . . . . . . . . . .
3.4.1 The Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.2 The Main Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.3 The Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.4 Strenghts and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . .
3.5 Parking Garage: de Neufville, Scholtes and Wang . . . . . . . . . . . .
3.5.1 The Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.2 The Main Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.3 The Demand Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.4 The Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.5 Strenghts and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . .
3.5.6 The Generalized Demand Model . . . . . . . . . . . . . . . . . . .
3.6 Summary Real Options Methods . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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The Impact of Probability Distributions . . . . . . . . . . . . . . . . . . . . .
4.1 Uniform Distribution, Beta Distribution
and PERT-Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1.1 The Uniform Distribution . . . . . . . . . . . . . . . . . . . . . . .
4.1.2 The Beta Distribution . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1.3 The PERT-Distribution . . . . . . . . . . . . . . . . . . . . . . . . .
4.2 Design Comparative Study Probability Distributions . . . . . . . . .
4.3 Results Simulation Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.1 Simulation Results of Different Parameter
Values of the Beta Distribution . . . . . . . . . . . . . . . . . . .
4.3.2 Results Comparative Study of Three Probability
Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

About the Author

Linda Peters is PhD Candidate in the field of Applied Economics at the University
of Antwerp. As a PhD candidate, she is involved in the application of Real Options
theory to Global Public Policy and her research contributes to bridge the gap
between theory and practice. Her research interests include Real Options, Global
Public Policy, Social Protection, Models of Decision-Making, and Probability
Distributions.

vii

Introduction

Large investment projects with a long time horizon are subject to many internal
(i.e., technical) and external (i.e., market) uncertainties. In a process of project
evaluation, practitioners traditionally use capital budgeting techniques, such as net
present value, decision tree-, scenario- and sensitivity analysis. Unfortunately, these
methods cannot fully quantify these uncertainties. Real options analysis (ROA)
does provide the necessary tools and techniques to deal with uncertainty and is
much appreciated as a complement to traditional valuation methods.
ROA literature is usually filled to the brim with partial differential equations,
probability density functions and simulation techniques, which is supposed to
convince us of the added value of ROA. Unfortunately, practitioners are not
convinced about the applicability of ROA. They experience difficulties regarding
the implementation of the method and perceive ROA as a black box. This has not
been much of a surprise since ROA is complex and incorporates many restrictive
assumptions. So, how can we prevent ROA to be just another forgotten paradigm in
the world of finance?
Standard ROA literature usually incorporates the headlines of the methodology,
whereas practitioners seek for an in-depth explanation in order to reproduce and
apply it to their own field. We believe this is the key to improve the accessibility of
ROA for practitioners. Therefore, this book explains the standard ROA literature
step by step, without the use of complex math. Practitioners are provided with a real
options framework and are encouraged to study the methodology in-depth instead
of giving up after reading the introduction. The reader will have a better grasp about
how ROA works and will be able to provide his or her judgment about ROA, since
all the basics of ROA and its pros and cons are discussed in this book.
Don’t expect to be an expert of ROA or to develop new and complex ROA
methodologies after reading this book. However, you are sufficiently equipped with
the ROA basics and its framework, which enables you to perform independent
future research. From this, you can judge whether or not ROA is of any value to
your field. We wish you good luck and have fun while reading this introductory
book about Real Options Analysis.
ix

x

Introduction

This book is structured as follows. Chapter 1 discusses the basic concepts of real
options analysis. Chapter 2 provides a comparative study between real options and
other traditional capital budgeting techniques and from this it is shown that traditional valuation models cannot capture the flexibility to adapt an investment
decision in response to the uncertainty. Chapter 3 discusses the most widely used
real option models in an accessible way and also highlights the important strengths
and weaknesses of these models. Chapter 4 explains and addresses the importance
to study the impact of probability distributions on real options valuation. Chapter 5,
the final chapter, provides a glossary of terms that are commonly used on the field of
real options.

Chapter 1

Introduction to Real Options Analysis

This chapter provides an introduction to the real options way of thinking. The
valuation methods of real options are based on the option pricing theory for
financial securities. Therefore in the first part of this chapter the basic concepts of
financial options will be discussed. Real Options Analysis apply these basic concepts to real or physical assets. The second part of this chapter commences with the
translation of financial to real option theory. Thereafter, a simple example is
presented to illustrate the use of option pricing to value a deferral option and to
describe the strengths and weaknesses of real options. In the concluding part,
different option valuation methods such as dynamic programming, contingent
claims and Monte Carlo simulation, are discussed.

1.1

Options

Real options provide decision makers the opportunity to make and capitalize on
emerging opportunities during the lifetime of the project. Decision makers have the
choice to defer, expand or cease an investment project. These opportunities suddenly can become available, cease to exist or be enforced. Decision makers are
responsible for making the right decision, i.e. the decision that maximizes the
potential value of the project and reduces the downside risk. The value of the
project is defined in terms of cash. In order to select the best project, decision
makers will estimate the value of the embedded options in the project and select the
one with the highest option value. Crucial to the valuation of options is uncertainty
or volatility. This fundamental parameter complicates the valuation of real options,
but at the same it adds significant value to projects. Real options acknowledges the
value of uncertainty in investment decisions and provides solutions for handling
these uncertainties. Unfortunately, decision makers who only use traditional capital
budgeting techniques often underestimate or ignore the extent of uncertainty and its
implications.
© Springer International Publishing Switzerland 2016
L. Peters, Real Options Illustrated, SpringerBriefs in Finance,
DOI 10.1007/978-3-319-28310-4_1

1

2

1 Introduction to Real Options Analysis

Real option reasoning is a heuristic based on the logic of financial options.
Therefore, this section starts with the basics of financial option valuation and
thereafter translates it to the principles of real option valuation.

1.1.1

Basics of Option Theory

In finance, an option is a contract which gives the owner the right, but not the
obligation, to buy or sell an underlying asset at a specified price on or before a
specified date. Options can be created on almost any asset, such as stocks, bonds or
currencies. The price at which the underlying asset can be purchased or sold is
called the exercise price or strike price and is determined at the time the option
contract is formed. The owner has the right to determine whether or not to exercise
the option. The option will only be exercised whenever it’s profitable to do so. The
payoff of the option when it’s not exercised equals zero. In other words, the payoff
of the option cannot be negative, apart from the option premium.

1.1.1.1

Call Option and Put Option

There are two types of options: calls and puts. A call option on a stock gives the
buyer or holder the right (but not the obligation) to buy the stock at a particular price
within a specified period of time. For example, if you buy a 1-week European call
option (exercised at expiration) on a stock with an exercise price of $30, you will
have the right to buy from the option’s seller one stock for the exercise price of
$30 at expiration (after 1 week), irrespective of the stock’s price at that time.
Suppose the stock goes up to $50 at the time the call expires, then you will be
able to exercise the call to buy the stock for $30 and immediately sell it in the
market for $50. The stock price rise to $50 represents a profit of
$50  $30 ¼ $20, in other words the call’s payoff equals $20: the option has
intrinsic value. In this case a call option is said to be in-the-money, i.e. when the
exercise price is lower than the stock price. If the stock price decreases to $15, you
will not exercise the option, since this will result in a loss. The option has no
intrinsic value, the minimum payoff is zero, and therefore the option is said to be
out-of-the-money.
Determining the value of the option is crucial for the buyer to decide whether or
not to buy the call. One of the primary determinants of option value is the volatility.
These issues play a key role in Real Options Analysis.
The second type of option is a put option. A put option gives the holder the right
to sell the stock at a particular price within a specified period of time. A put option
can be viewed as the opposite of a call option.

1.1 Options

1.1.1.2

3

Long Position and Short Position

In the previous example we have introduced the buyer of the call option. This is also
referred to as the investor who has taken the long position (i.e. has bought the
option). The seller or writer of the option takes a short position. This means that the
investor has sold or written the option. The seller of an option receives cash up
front, but has potential liabilities later. The seller’s profit or loss is the reverse of
that for the buyer of the option. It’s a so-called zero-sum game.

1.1.1.3

American Option and European Option

Another important distinction in options terminology is between an American and a
European option. With an American option you have the right to exercise the option
at any time during its life. European options give you the right to exercise an option
only at the end of its life. Options traded on option markets are usually American
options, whereas non-traded options are usually European.

1.1.1.4

The Basic Idea of Valuation

Option value plays a key role when an investor has to decide whether or not to buy
or sell an option. Even though several methods have been developed to value an
option, the underlying concept is the same for each method and is as follows. A
company creates value by investing only in projects where the (discounted) project
inflows outweigh the (discounted) project outflows. Market (present) value is
defined as the future sum of cash flows given a specified rate of return, where
future cash flows are discounted at the discount rate. This basic concept is essential
in Real Option Valuation and the challenge is to determine the market (present)
value of the expected cash inflows.

1.1.1.5

Hedging

Another key concept in financial theory and often applied to the valuation of
options is hedging. Hedging is a way of reducing risk, such as the risk in a project,
by one or more transactions in the financial markets. A hedge can be constructed
from many types of financial instruments such as futures and options. A future is a
bilateral contract (as is the case with options) that allows one party, the seller, to sell
a particular reference asset at a forward price for settlement at a future date, and the
second party, the buyer, to purchase the reference asset at the forward price on a
named date. The difference between futures and options is that a future contract is a
legal obligation to both counterparties, one to deliver and the other to accept the
delivery. In real options analysis a hedge is constructed from an option. Therefore,

4

1 Introduction to Real Options Analysis

only this type of hedging is discussed and illustrated with an example of
Hull (2009).
Let’s suppose we own 1,000 Microsoft shares at the current price of $28 per
share. We expect that the price of the Microsoft share will drop dramatically and
therefore we need to hedge against such a price decrease. Our hedge involves the
purchase of 10 put options for the month July at the strike price of $27.50 in order to
have the right to sell 1,000 shares at a price of $27.50 per share. If the price of the
put option is $100, the cost of the hedging strategy will be 10  $100 ¼ $1,000.
This means a guarantee of at least $27.50 per Microsoft share. If the stock price
exceeds the $27.50, the option will not be exercised since it has no value. By doing
this, we have taken a hedging position for a price guarantee of $1,000 against a
maximum potential exposure of 1,000  ð$28  $27:50Þ ¼ $500.

1.1.2

From Financial Options to Real Options

In the previous section we’ve introduced the fundamental essence of financial
options. The basic characteristics of these financial options could be recognized
in real-life investment projects. For example the opportunity to sell an investment
project is equivalent to a put option. The equivalent of a financial option with regard
to real-life investment projects are real options. ‘Real’ refers to real-life investment
projects or physical assets in comparison to the ‘intangible’ financial options. Real
options are generally distinguished from financial options in that they are not
typically traded as securities. However, real options are modelled in such a way
as if they are traded.
A real option gives the right, but not the obligation, to take different courses of
action (for example to defer, abandon or expand) with respect to real assets at a
predetermined price at a certain time in the future. Real Options Analysis supports
managers to formulate and obtain their strategic objectives and maximize the value
of the shareholders or investors.
Copeland and Antikarov (2001) lists five essential key levers of real options and
add an important sixth lever:
1. The value of the underlying asset or stock price. The underlying asset of a real
option is a project, investment or an acquisition. If the value of the underlying
asset increases, the real option value, when it’s equivalent to a call option,
increases as well. Conversely, if the value of the underlying asset increases,
the value of a put option decreases. Real options are generally distinguished
from financial options in that the owner of the real option has the ability to
influence the value of the underlying asset, whereas this is not possible with
regard to financial options.
2. Exercise price or investment cost. The exercise price is the premium paid for
acquiring the asset (with a call option) and in case of a put option it is the
premium received for selling the asset. As the exercise price of an option

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