Appendix 7.1: Real Options versus Financial Options

Abstract

Real Options versus Financial Options R eal options are not financial options; real options represent certain types of management decisions. The options models used to value real options are borrowed from financial options pricing models, but the underlying assumptions of these financial models do not strictly apply to real options. A financial option is a derivative instrument whose value depends on the volatility of the underlying financial securities from which it is derived. Financial options are a right, but not an obligation, to buy or sell an underlying financial asset at a fixed price over a specified time period. For stock options, the underlying financial assets are equity securities; for currency options, the underlying asset is cash denominated in different currencies; and so on. For instance, a financial stock option (a put or a call) is traded on a regulated options exchange (e.g., the Chicago Board of Options Exchange). The traded option relates to a particular quoted equity security that is trading on a stock exchange, say the New York Stock Exchange or on the NASDAQ. Behind real options are capital budget and resource allocation decisions. These managerial decisions are normally related to illiquid assets, such as research and development (R&D) projects, natural mineral resources, real estate, or investments in other types of nonfinancial tangible or intangible assets (e.g., plant and equipment or intellectual property). The underlying assets for real options do not normally trade on financial exchanges where market prices are observable. The assets underlying real options are illiquid and hard to trade. If they are being traded, they are usually being bought and sold in inefficient markets, such as in one-on-one negotiated transactions between companies or individuals, not on regulated market exchanges. Consequently, the assumptions behind the standard models used to value financial options do not strictly apply to the conditions of most real options. For instance, the Black-Scholes option pricing formula, published by Fischer Black and Myron Scholes in 1973, is designed to be used when there is a single source of uncertainty as measured by the volatility of the underlying asset (technically the standard deviation squared of the asset returns) and a single decision date (the time of exercising the option is fixed on a certain date). 1 Real options are decision choices about real assets that a manager may exercise in the future. 2 Many real options are contingent on more than one source of uncertainty and so should be classified as compound real options or options on an option. 3 Real-life investment projects often include a collection of these compound real options whose values may interact. 4