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security or set of securities whose cash flows are correlated with those of the realasset. If, however, the spanning assumption will not hold, then dynamic program-ming and decision analysis offer alternative valuation methods to solving realoptions problems when traded values are not available.The application of financial market models such as Black–Scholes to value realoptions can present problems. The financial markets are littered with experienceswhere financial models were applied that were not suited to the market environ-ment and with assumptions that were not valid. A large component of the value inapplying real options lies in the insights gained from the actual process of ananalysis. Quantitative models and methods are tools that facilitate the analyticalprocess and provide an abstraction of the problem. They are not black boxes thatjust produce a number, and are certainly not some enchanted device that providesinstant and perfect solutions.Another issue is that while a real option analysis may be theoretically correct, itmay not have any significant influence on an organization’s management decisions.A real options analysis has to consider an organization’s culture, decision andmanagement processes. This not only includes how an organization is managed andhow decisions are made, but also how on occasions mistakes can be made.Increasing the effectiveness of a real options analysis within an organizationincludes identifying and communicating any limitations, and also seeking anypotential interactions with other management disciplines such as industry analysisand competitor analysis.What a real options framework does offer is the potential to combine strategicand financial analysis, and integrate investment decisions with corporate strategyand value. Real options can clarify management decisions by supporting strategicopportunities with values that are aligned with the financial markets, and providethe means to communicate these values to the financial markets. The real options
concept also has the potential to enhance the aggregation of an organization’sproject values and the management of its risk exposures. Real option techniqueswill become a powerful component of an organization’s strategic analysis, valua-tion, decision and risk management processes. As the business environmentbecomes more unpredictable and the implications of making incorrect businessdecisions continue to rise, the demand for sophisticated analytical disciplines suchas real options is likely to grow rapidly.134STRATEGY, VALUE AND RISK – THE REAL OPTIONS APPROACH
135IndexAaccounting metrics, andmanagement, 11American options, 46and dividends, 48, 61and trees, 79, 80, 81ARCH and GARCH models, 66Bbackwardation, in energy forwardcurves, 110binomial trees, 77, 80and biotechnology, 125–8and information technology,104–7and the replicating portfolio, 61,62and trinomial trees, 81biotechnology,case study, 25–31, 120–30and pharmaceuticalpartnerships, 26Black–Scholes–Merton modelling,74–6Black–Scholes model, 61, 74,75–6, 85dividend adjustment, 76

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