Real Options Alex
REAL OPTIONS:
STATE OF THE PRACTICE
by Alex Triantis,
University of Maryland, and
Adam Borison,
Applied Decision Analysis/
PricewaterhouseCoopers1
n an economic environment characterized by rapid change, great uncertainty, and the need for flexibility, it has become increasingly important for corporate managers to use investment evaluation tools and processes that properly account for both uncertainty and the company’s ability to react to new information. Real options has emerged as an approach that addresses this challenge more successfully than traditional capital budgeting techniques.
What makes real options analysis so effective in the current business climate is its explicit recognition that future decisions designed to maximize value will depend on new information—such as changes in financial prices or market conditions—that will not be available or obtained until after the initial investment is made. It is in this sense that real options resemble financial options: just as the value of a stock option, and the investor’s decision to exercise it, depend on the future stock price, the exercise decision of a real option is based on the future value of an underlying real asset—that is, the future value of the Investment project. The real options approach thus builds on the theory and insights developed for pricing financial options, while also making use of techniques from the discipline of decision analysis.
In the mid-1980s, academics began building option-based models to value investments in real assets, laying the foundation for an extensive academic literature in this area.2 The 1990s saw numerous conferences, several books, and many articles aimed at practitioners,
and companies began to experiment with these techniques.3 Now, as we approach the end of 2001, real options has established a solid, albeit limited, foothold in the corporate world. Given this evolution, it is fair to ask, “How is real options being practiced and what impact is it having in
STATE OF THE PRACTICE
by Alex Triantis,
University of Maryland, and
Adam Borison,
Applied Decision Analysis/
PricewaterhouseCoopers1
n an economic environment characterized by rapid change, great uncertainty, and the need for flexibility, it has become increasingly important for corporate managers to use investment evaluation tools and processes that properly account for both uncertainty and the company’s ability to react to new information. Real options has emerged as an approach that addresses this challenge more successfully than traditional capital budgeting techniques.
What makes real options analysis so effective in the current business climate is its explicit recognition that future decisions designed to maximize value will depend on new information—such as changes in financial prices or market conditions—that will not be available or obtained until after the initial investment is made. It is in this sense that real options resemble financial options: just as the value of a stock option, and the investor’s decision to exercise it, depend on the future stock price, the exercise decision of a real option is based on the future value of an underlying real asset—that is, the future value of the Investment project. The real options approach thus builds on the theory and insights developed for pricing financial options, while also making use of techniques from the discipline of decision analysis.
In the mid-1980s, academics began building option-based models to value investments in real assets, laying the foundation for an extensive academic literature in this area.2 The 1990s saw numerous conferences, several books, and many articles aimed at practitioners,
and companies began to experiment with these techniques.3 Now, as we approach the end of 2001, real options has established a solid, albeit limited, foothold in the corporate world. Given this evolution, it is fair to ask, “How is real options being practiced and what impact is it having in