Download Real options Primer

Real Options :
A primer
Based on the book by
Martha Amram and
Nalin Kulatilaka
Introduction

Real options are useful under the following
conditions:
 Contingent investment decisions
 High uncertainty
 Need to wait for more information
 Value lies in future growth options
 Flexibility is important
 Mid course corrections may be needed as the scenario unfolds
 The pay offs to investments are non linear
 Conventional tools fail to capture the upside potential and trade
offs required in strategic decisions.
Different investment situations
Irreversible investments
 Flexibility investments
 Insurance investments
 Modular investments
 Platform investments
 Learning investments

Irreversible investments
May need to be delayed
Or broken into stages
Options may exist
These options help truncate losses
Flexibility investments
Build options into the initial design
 Eg Flexible Manufacturing System
 Eg Time related flexibility
 Flexibility is difficult to handle with traditional
financial tools

Insurance investments

These are kinked pay offs that cannot be
dealt with by traditional tools that handle
linear pay offs.
Modular investments
Options can be created through product
design
 Modular product can be viewed as a
portfolio of options to upgrade.

Platform investments

Create valuable follow on investment
opportunities.
Learning investments

These generate information that is not
otherwise available.
The broad approach
Understand the implications of uncertainty.
 Bring insights to other investments.
 Focus on total risk.
 Consider the full range of outcomes.
 Go beyond financial tools which consider
only systematic risk.

The Black Scholes Option pricing
model
Consider a portfolio of traded securities.
 This is called a tracking portfolio.
 It has the same pay offs as the option.
 Impose no arbitrage condition.
 The value of the option equals the value of
the portfolio as the stock price moves.
 This is the basis for Black Scholes model.

Inputs needed for valuing an option
Current value of underlying asset.
 Time to decision date
 Investment cost
 Strike price
 Risk free rate of interest
 Volatility of underlying asset
 Cash payouts/non capital gains

The building blocks of real options

Real options may have complex pay offs.
But the building blocks are simple:
 Buy a call option
 Write a call option
 Buy a put option
 Write a put option
 Go long on underlying asset
 Go short on underlying asset
A call option enables an investor to take
advantage of potential good news or high
values of the underlying asset.
 A put option enables an investor to take
advantage of potential bad news or low
values of the underlying asset.
 A call option is appropriate for a bullish
investor.
 A put option is ok for a bearish investor.

Challenges in dynamic tracking

Two features of underlying assets cause
tracking error :
Costs of tracking
Quality of tracking
Leakages in value
Real assets may generate cash payments
similar to a dividend.
 Convenience yield may result from holding
the asset.
 These benefits are available only to the
holder of the underlying asset, not to the
option holder.

Basis risk
The traded securities in the tracking portfolio
may not be perfectly correlated with the
value of the option.
 The imperfect correlation may be the result
of product quality, delivery location, timing,
etc.

Private risk
Real options have risks that are not
contained in the available set of traded
securities.
 These private risks are not priced in the
financial markets.

Errors/costs in tracking
Infrequent trading
 Illiquidity
 Costs of coordinating, monitoring and
documenting
 Infrequent observability

Trade offs

Selecting securities for the tracking portfolio
often requires a trade off between a
security that is weakly correlated with the
underlying asset but with low tracking costs
and a security that is highly correlated but
with high tracking costs.
Framing a model requires trade offs.
 Novice users tend to include too many
uncertainties.
 Over specifying private risk increases model
error.
 In many cases, direct modeling of private
risk can be avoided because the financial
markets have priced the appropriate bundle
of risk.

Real options and discipline

The real options approach infuses the strategy
creation process with discipline because it :
 Expands the menu of resources and strategic
alternatives evaluated
 Expands the range of markets evaluated
 Illuminates the risk of strategic alternatives
 Provides consistent comparison of internal projects,
contracts and market transactions.
 Illuminates the value of and risk in contracts
 Focuses on the right questions
 Acknowledges the role of luck.
Key insights and perspectives
A higher level of uncertainty increases the
value of an option. During uncertainty, an
option limits the downside while protecting the
upside.
 Options may create value but they come at a
price.
 We should start with a simple and transparent
framework and avoid over modelling private
risk. If the relevant risks are captured in
traded securities, we must use them.

Real options thinking is about expanding the
set of feasible alternatives.
 Real options encourage us to think far and
wide.
 Many investment opportunities are rejected
because traditional tools ignore the options
for follow on investments.
 Options to delay, to temporarily shut down,
to abandon and to rewrite investment plans
in mid stream can significantly increase
value.

Look to the financial markets for relevant
information. Even if the key focus is private
risk, financial markets may provide valuable
information.
 Don’t aim for too much precision. Strategic
investment decisions should be dynamically
updated and revised over time.
 It is not realistic to pin down the entire
investment schedule at any time, only the
range of possible outcomes.
 We must focus more on getting the problem
right rather than on minute details.

The organisational culture must encourage
the use of real options.
 Trigger mechanisms must be activated
when there are changes in the critical value
of the underlying tracking asset.
 Teams consisting of different people must
be involved to identify investment
opportunities, develop the necessary
quantitative tools and communicate clearly
to the top management.

Four steps to using real options

Frame the application
Identify the decisions
What kind of uncertainties are involved?
Set up the decision making rule.
Link to the financial markets
Review for transparency and simplicity

Implement the option valuation model
Establish the inputs
Value the decision using option calculator

Review the results

Redesign if necessary.
Three ways of calculating option
values



Partial differential equation approach. The change
in the option value is equated with the change in
the value of the tracking portfolio.
Dynamic programming – Lay out possible future
outcomes and fold back the value of the optimal
future strategy.
Simulation approach – Average the value of the
optimal strategy at the decision date for thousands
of possible outcomes.
Illustration

Mega Pharm wants to fill in a gap in it
product line and has proposed to Bio Line
that it will invest $ 35 million today for rights
to buy Bio Line for $ 200 million in three
years. Current market value of Bio Line is
$192 million. Is the deal attractive?
Current value = 192
 Strike price = 200
 Time to expiration = 1095 days
 Assume Volatility = 30%
 Assume R = 5%
 We use an option calculator as shown on
the next slide.

Illustration

Georgia Properties has an option to buy a
property in 6 weeks at $ 82 million. The
property generates $ 2.5 milion per month in
lease income. At the end of 4 weeks, there
will be a single payment to the REIT from
rental income. Current price as indicated by
a traded REIT is $80 million, volatility is 25%
and r= 5%.
A= 80-2.49= 77.51
 X = 82
 R=5%, Volatility = 25%
 Time to expiration = 42 days
 We use the option calculator again.

Calculation without considering
leakage
Illustration

CNet a tech company is planning to acquire
Hot Ring. There is an option to acquire 51%
of Hot Ring in two years for $ 33.2 million.
What is the value of the option? The current
value of Hot Ring is $ 30.6 million. The risk
free rate of return is 5% and the annual
stock price volatility is 45%. No dividend is
expected for the next 2 years.
Current value = 30.6
 R= 5%.
 Volatility = 45%
 Strike price = 33.2
 Time = 2 years = 730 days
 Again we use the option calculator
