Bob Jensen's Threads on Real Options, Option Pricing Theory, and Arbitrage Pricing Theory

Bob Jensen at Trinity University

Many moons ago, Stewart Myers and I were in a doctoral program together at Stanford University.  After graduation, Stewart became one of the most outstanding economics and financial researchers of the world --- http://mitsloan.mit.edu/vpf/facstaff.cfm?ID=95&ProfType=F&sortorder=name 

The term "real options" can be attributed to the Stewart Myers ("Determinants of Capital Borrowing", Journal of Financial Economics, Vol..5, 1977).  The theory of real options extends the concept of financial options (in particular call options) into the realm of capital budgeting under uncertainty and valuation of corporate assets or entire corporations.

The real options approach is dynamic in the sense that includes the effect of uncertainty along the time, and what/how/when the relevant real options shall be exercised.  Some argue that real options do little more than can be done with dynamic programming of investment states under uncertainty, real options add a rich economic theory to capital investing under uncertainty.

The real options problem can be viewed as a problem of optimization under uncertainty of a real asset (project, firm, land, etc.) given the available options.  Since I have been asked to teach a bit about real options theory while I am lecturing at Monterrey Tech March 18-23, I thought I might share a bit of my source material that I discovered on the Web.

Real Options are mentioned in the FASB's  "Special Report: Business and Financial Reporting, Challenges from the New Economy," by Wayne Upton, Financial Accounting Standards Board, Document 219-A, April 2000 --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 

Wayne Upton writes as follows on pp. 91-93:

Measurement and Real Options 

Perhaps the most promising area for valuation of intangible assets is the developing literature in valuation techniques based on the concept of real options. Techniques using real options analysis are especially useful in estimating the value of intangible assets that are under development and may not prove to be commercially viable.

A real option is easier to describe than to define. A financial option is a contract that grants to the holder the right but not the obligation to buy or sell an asset at a fixed price within a fixed period (or on a fixed date). The word option in this context is consistent with its ordinary definition as “the power, right or liberty of choosing.”  Real option approaches attempt to extend the intellectual rigor of option-pricing models to valuation of nonfinancial assets and liabilities. Instead of viewing an asset or project as a single set of expected cash flows, the asset is viewed as a series of compound options that, if exercised, generate another option and a cash flow. That’s a lot to pack into one sentence. In the opening pages of their recent book, consultant Martha Amram and Boston University professor Nalin Kulatilaka offer five examples of business situations that can be modeled as real options: 56 

• Waiting to invest options, as in the case of a tradeoff between immediate plant expansion (and possible losses from decreased demand) and delayed expansion (and possible lost revenues) 

• Growth options, as in the decision to invest in entry into a new market 

• Flexibility options, as in the choice between building a single centrally located facility or building two facilities in different locations 

• Exit options, as in the decision to develop a new product in an uncertain market 

• Learning options, as in a staged investment in advertising.

 Real-options approaches have captured the attention of both managers and consultants, but they remain unfamiliar to many. 

Proponents argue that the application of option pricing to nonfinancial assets overcomes the shortfalls of traditional present value analysis, especially the subjectivity in developing risk-adjusted discount rates. They contend that a focus on the value of flexibility provides a better measure of projects in process that would otherwise appear uneconomical. A real-options approach is consistent with either fair value (as described in Concepts Statement 7) or an entity-specific value. The difference, as with more conventional present value, rests with the selection of assumptions. If a real option is available to any marketplace participant, then including it in the computation is consistent with fair value. If a real option is entity-specific, then a measurement that includes that option is not fair value, but may be a good estimate of entity-specific value.

Thank you for sharing Ulrich Hommel --- http://www.real-options.de/ 

Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments.

Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio.

The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project.

Traditional methods (e.g. net present value) fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change.

The real options method represents the new state-of-the-art technique for the valuation and management of strategic investments.

The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk.

This site is maintained by Ulrich Hommel and the Chair of Investment and Risk Management of the European Business School (Oestrich- Winkel) as a free service to the scientific and management community. If you have any information on the real options method that you wish to make available to the public via this web site, please contact

M.Sc. Dissertation Abstract: Real Options in R&D Capital Budgeting - A Case Study at Pharmacy & Upjohn. By M.Sc. Gunnar Kallberg and M.Sc. Peter Laurin, from Gothenburg School of Economics and Commercial Law, Department of Economics, Sweden. The abstract can be found under Item 5 at http://www.puc-rio.br/marco.ind/contrib1.html 

Despite the wide use of the traditional capital budgeting techniques NPV, IRR, and Payback time among organizations, criticism have been raised against the static use of them. The techniques only use tangible factors and do not take into account intangible factors such as future competitive advantage, future opportunities, and managerial flexibility. A relatively new technique to capital budgeting is the real option approach. This approach has the potential to include the value of the project from active management and strategic interactions using the valuation technique for financial options.

The main objective of this thesis is to numerically analyze the value of an option approach in the capital budgeting of R&D investments. The results of the option approach will be compared with the results from traditional NPV approach. This will be done by constructing a valuation model and this model will then be numerically applied to a pharmaceutical R&D project at Pharmacia & Upjohn.

The model that we have constructed includes both the binomial and the Black & Scholes formula for the valuation of options. The binomial method is used in valuing the development phase of the R&D project and the Black & Scholes formula is used when valuing a follow-on project. A common spreadsheet program has been used to construct the model.

If you can overlook some of the English grammar mistakes (mainly when the authors' native language is something other than English), take a look at the following helpful free documents on the use of real options in capital budgeting.  

Real Options --- http://www.puc-rio.br/marco.ind/multimid.html#Chicago2000 

A great Website on real options --- http://www.puc-rio.br/marco.ind/main.html 

Note especially the Visual FAQ's on Real Options --- http://www.puc-rio.br/marco.ind/faqs.html 

Underlying all of this is Options Pricing Models and Arbitrage Pricing Theory.  In that realm, I have an aged (yellowed?) 1984 working paper that journal editors claimed they could just not understand and would not touch with a ten foot pole.  Am I the only one who finds my stuff to be crystal clear?

Working Paper 149
Does a Ross Economy Lunch Really Cost as Much as Hirshleifer Cuisine Complete With Sigma Squared for Dessert? 
http://www.trinity.edu/rjensen/149wp/149wp.htm  

You can find more about such things in papers and books that really did get published in such journals as those listed below:  

Accounting Theory

"CPAs Find 'Real Options' for Business Valuation," Journal of Accountancy, February 2002, Page 22 --- http://www.aicpa.org/pubs/jofa/feb2002/cpa2biz.htm#c2 

CPA valuators are increasingly finding that clients are asking for more than just a final number in their estimates. Instead, the market is pushing CPAs for a more holistic approach. And CPAs are responding with a new school of practice called real options theory.

“Real options theory is connected more to operational or corporate theories, as opposed to the financial aspects of the investing arena,” explains Steven E. Sacks, a CPA and the CPA2Biz senior product manager in charge of BV issues. “Heretofore, the recognized valuation methods have been inadequate for forecasting revenue streams and have completely ignored the opportunities management can avail themselves of through different courses of action.”

These different courses of action can result in a difference between the price of a business as measured by the stock market value and the intrinsic value, a concept typically used by financial analysts, explains Sacks, who was an advocate of the BV mission at the AICPA long before joining CPA2Biz.

Take some real world examples: Time Warner’s merger with AOL to expand its distribution network via an online environment. Yahoo!’s decision to extend its portal services into the Internet auction business. Or, eBay’s purchase of Half.com and Butterfield & Butterfield.

Books recommended by the Harvard University Project Finance Portal --- http://www.hbs.edu/projfinportal/relatedfinance.htm 

Real Option Analysis:

Amram, M., and N. Kulatilaka, 1999, Real Options: Managing Strategic Investment in an Uncertain World, (Harvard Business School Press, Boston, Mass.).

Brennan, M., and E. Schwartz, A New Way of Evaluating Natural Resource Investments, 1985, Midland Journal of Corporate Finance, 3, pp. 78-88.

Copeland, T., and P. Keenan, 1998, Making Real Options Real, The McKinsey Quarterly, No. 3, pp. 128-141.

Dixit, A. K., and R.S. Pindyk, 1994, Investment Under Uncertainty, (Princeton University Press, Princeton, New Jersey).

Dixit, A. K., and R.S. Pindyk, 1995, The Options Approach To Capital Investment, Harvard Business Review, May/June, pp. 105-115.

Kemna, A.G.Z., 1993, Case Studies On Real Options, Financial Management, Autumn, pp. 259-270

Kulatilaka, N., and A. Marcus, 1992, Project Valuation Under Uncertainty, Journal of Applied Corporate Finance, Fall, pp. 92-100.

Leslie, K., and M. Michaels, 1997, The Real Power of Real Options, The McKinsey Quarterly, No. 3.

Leslie, K., and M. Michaels, 1998, The Real Power of Real Options, Corporate Finance 158, January, pp. 13-20.

Majd, S., and R.S. Pindyck, Time to Build, Option Value, and Investment Decisions, Journal of Financial Economics 18, pp. 7-27.

McDonald, R., and D. Siegel, 1986, The Value of Waiting to Invest, The Quarterly Journal of Economics 101, November, pp. 707-27.

Myers, S.C., and S. Majd, 1990, Abandonment Value and Project Life, Advances in Futures and Options Research 4, pp. 1-21.

Siegel, D., J. Smith, and J. Paddock, 1987, Valuing Offshore Oil Properties with Option Pricing Models, Midland Journal of Corporate Finance, 5, pp. 22-30.

Trigeogis, Lenos, 1996, Real Options: Managerial Flexibility and Strategy in Resource Allocation, (The MIT Press, Cambridge, MA).

Trigeorgis, L., 1996, Interactions Among Multiple Real Options, Chapter 7 in Real Options: Managerial Flexibility and Strategy in Resource Allocation, (The MIT Press, Cambridge, MA).

Lattices and Real Options
"Using Real Options Software to Value Complex Options," by Jonathan Mun, Financial Engineering News --- http://www.fenews.com/fen27/RealOptions.html

Real options are crucial in

* Identifying different corporate investment decision pathways or projects that management can navigate given the highly uncertain business conditions;
* Valuing each of the strategic decision pathway and what it represents in terms of financial viability and feasibility; * Prioritizing these pathways or projects based on a series of qualitative and quantitative metrics;
* Optimizing the value of your strategic investment decisions by evaluating different decision paths under certain conditions or using a different sequence of pathways can lead to the optimal strategy;
* Timing the effective execution of your investments and finding the optimal trigger values and cost or revenue drivers; and
* Managing existing or developing new optionalities and strategic decision pathways for future opportunities.

In financial options analysis, there are multiple methodologies and approaches used to calculate an option's value. These range from using closed-form equations like the Black-Scholes model and its modifications, Monte Carlo path-dependent simulation methods, lattices (for example, binomial, trinomial, quadranomial and multinomial trees), variance reduction and other numerical techniques, to using partial-differential equations, and so forth. However, in real options analysis, the mainstream methods that are most widely used are the closed-form solutions, partial-differential equations, and the binomial lattice trees.

The real options approach incorporates a learning model, such that management makes better and more informed strategic decisions when some levels of uncertainty are resolved through the passage of time. The discounted cash flow analysis assumes a static investment decision, and assumes that strategic decisions are made initially with no recourse to choose other pathways or options in the future. To create a good analogy of real options, visualize it as a strategic road map of long and winding roads with multiple perilous turns and branches along the way. Imagine the intrinsic and extrinsic value of having such a road map when navigating through unfamiliar territory, as well as having road signs at every turn to guide you in making the best and most informed driving decisions. This is the essence of real options.

Approaches in Solving Real Options Problems

Continued in article

Bob Jensen's threads on options valuation are at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#V-Terms

Dissertation and Working Paper Links --- http://www.puc-rio.br/marco.ind/contrib1.html

Contents:

I) Dissertations (Doctoral and M.Sc.) and Chapters/Papers from the Dissertations

 

 

 

 

 

 

 

 

 

 

 

II) Special Contributions

 

 

 

 

 

 

III) Working Papers

 

 

 

 

 

 

VI) Abstracts from Dissertations

 

 

Also see Bob Jensen's  Threads on Return on Investment (ROI)

Bob Jensen's Threads are at http://www.trinity.edu/rjensen/threads.htm 

Bob Jensen's Homepage is at http://www.trinity.edu/rjensen/