DERIVATIVES AND RISK MANAGEMENT Real Options (Lecture 5) Matti Suominen January 2018
SOME EXAMPLES WHERE REAL OPTIONS ARE IMPORTANT: High technology companies: Option to use developed technology elsewhere. Movie producers: Option to produce sequels to films. Paper companies: Option to switch paper type. Option to temporarily shut down the production. Brand products: Option to introduce other products under the same brand. Option to expand marketing to overseas. Natural resource industries: Option to expand / contract. Option to defer. Call: S = PV(FCF) EX = Cost of adapting technology & new investment Call: S = PV(FCF) EX = Cost of filming the new film Swaption ? S = Δ PV(FCF) EX = Cost of changing the paper type Second: Put? Call S = PV(FCF) EX = Cost of marketing Call / Put S = Δ PV(FCF) EX = Cost of new investment; scrap value Option vs. S-EX
In principle we can use the same techniques to price real options as financial options. The use of option pricing techniques is most straightforward: If the underlying is traded. If we can replicate the underlying indirectly. If the underlying has zero beta. In real options the underlying security is typically the value of the project if the project is taken.
Example: 1 year lease on a gold mine Extract up to 100,000 oz.