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web-realoptions - WEB CHAPTER III Real Options Tough...

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WEB CHAPTER III Real Options Tough Techniques for Tough Problems. web-realoptions.tex: ©Ivo Welch, 2004. Confidential: Access by Permission Only! last file change: Feb 23, 2006 (13:39h). compile date: Thursday 30 th March, 2006 (14:02h). This chapter offers a much more detailed discussion of real options compared to what you learned originally in Chapter ?? . (You must read Chapter ?? before you read this web chapter!) Assessing the value of real options is as important as it is difficult. This web chapter should help you learn how to think about and solve these difficult NPV problems. It relies more heavily on statistical concepts than the rest of the book. Side Note : Some academics refer exclusively to “valuation by replication” (explained in Section 3 · 3.D ) as the “real options” approach. However, this chapter refers to “real options” as options embedded in real projects, which can be valued through a number of different techniques, “valuation by replication” being one of them. Anecdote : An Early Real Option The earliest known option contract was also a real option. It was recorded by Aristotle in the story of Thales the Milesian, an ancient Greek philosopher. Believing that the upcoming olive harvest would be especially bountiful, Thales entered into agreements with the owners of all the olive oil presses in the region. In exchange for a small deposit months ahead of the harvest, Thales obtained the right to lease the presses at market prices during the harvest. As it turned out, Thales was correct about the harvest, demand for oil presses boomed, and he made a great deal of money. Source: Wisegeek’s “What Are Futures?” 53
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54 file=web-realoptions.tex: LP Web Chapter III. Real Options. 3 · 1. Types of Real Options The word option is a synonym for choice—the ability to do something or not do something Explicit and Implicit Financial Options. in the future, at your discretion. Financial options are common. The most familiar are stock options, which are traded, e.g., on the Chicago Board Options Exchange (CBOE). The prices of these options can be looked up on Yahoo! Finance . Some options are traded over the counter: if you want to purchase a 10-year option on the Sony, chances are that you would have to ask someone—typically an investment bank—to manufacture such an option for you. Other finan- cial options are embedded in contracts and securities. For example, your mortgage contract more than likely gives you the option to pay off the mortgage at your discretion, which you should do (and refinance) if interest rates drop enough. Your car insurance liability may have a deductible, which de facto means that the insurance is only an option that gives you the right to exercise it if the damage exceeds the deductible. But this chapter is not so much interested in financial options as it is in real options. What is the Real Options: Your choice to alter operations in the future.
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