REAL OPTIONS
in THEORY and PRACTICE
in THEORY and PRACTICE
All rights reserved.
About the Book
Decision-makers face a staggering array of problems in business and
economics. Managers of growing firms have to decide when to exercise
growth options and expand their business. Governments have to decide
whether to undertake large infrastructure investments. Managers of oil firms
must decide how rapidly to deplete their reserves. While these problems
seem quite diverse, they share many important features. In each case, the
decision maker must choose when to take a particular action that will be
difficult, if not impossible, to reverse. In each case, the consequences of
taking (or not taking) that action are uncertain. And in each case, the timing
and nature of the actions taken by the decision makers directly affect the
cash flows generated by the entities they manage.
This book explains how techniques originally developed to price financial
derivatives can be used to analyze real-world business and economic
decisions such as those described above. Known as "real options analysis",
this approach to decision-making is built on strong theoretical foundations. It
is widely discussed in the practitioner literature, but often at a fairly intuitive
level. What practitioners need -- and what this book delivers -- is a
structured approach to systematically applying real options analysis to the
wide variety of problems they will meet in business and economics.
Table of contents
Preface
1 Introduction
Part I: Foundations
2 The modeling framework
3 Valuing single-period cash flows
4 Valuing multi-period cash flows
5 Combining valuation and decision making
Part II: Component Real Options
6 Options that do not affect the state of a project
7 Simple timing options
8 Compound timing options
9 Uber-compound timing options
10 Switching options
11 Learning options
Part III: Calibrating the Model
12 Calibration using spot and futures price data
13 Calibration using option price data
14 Calibrating trees of alternative state variables
Part IV: Putting the Pieces Together
15 Forestry management and valuation
16 Developing a gas field
17 Mothballing an ethanol plant
18 Where to from here?
Bibliography
Full table of contents
Sample chapters and the index can be viewed at amazon.com
Underlying philosophy
All introductions to real options analysis highlight the relationship between
the real options embedded in many capital budgeting problems and the
financial derivatives that make up such a large part of the modern financial
system. The valuation techniques applied to real options originate in the
models used to price financial derivatives. However, there is a fundamental
difference between financial derivatives and real options:
Therefore, Real Options in Theory and Practice focuses on building up a general
approach to solving real options problems from the ground up. Rather than
aiming to build a "black box" to solve a small set of standardized real options
problems, it describes the building blocks of any successful real options
analysis and shows how they can be assembled in a way that is appropriate
to the problem being analyzed.
Intended audience
The intended audience comprises practitioners and students in the increasing
number of MBA/MSc-style courses on real options analysis.
In order to make the book accessible to a wide audience, the level of
mathematics has been kept at the level of the binomial option pricing model.
The book is designed to facilitate self-study. As well as being essential if
practitioners are to benefit, this fits in well with the flexible delivery methods
that are increasingly being adopted in post-experience education.
economics. Managers of growing firms have to decide when to exercise
growth options and expand their business. Governments have to decide
whether to undertake large infrastructure investments. Managers of oil firms
must decide how rapidly to deplete their reserves. While these problems
seem quite diverse, they share many important features. In each case, the
decision maker must choose when to take a particular action that will be
difficult, if not impossible, to reverse. In each case, the consequences of
taking (or not taking) that action are uncertain. And in each case, the timing
and nature of the actions taken by the decision makers directly affect the
cash flows generated by the entities they manage.
This book explains how techniques originally developed to price financial
derivatives can be used to analyze real-world business and economic
decisions such as those described above. Known as "real options analysis",
this approach to decision-making is built on strong theoretical foundations. It
is widely discussed in the practitioner literature, but often at a fairly intuitive
level. What practitioners need -- and what this book delivers -- is a
structured approach to systematically applying real options analysis to the
wide variety of problems they will meet in business and economics.
Table of contents
Preface
1 Introduction
Part I: Foundations
2 The modeling framework
3 Valuing single-period cash flows
4 Valuing multi-period cash flows
5 Combining valuation and decision making
Part II: Component Real Options
6 Options that do not affect the state of a project
7 Simple timing options
8 Compound timing options
9 Uber-compound timing options
10 Switching options
11 Learning options
Part III: Calibrating the Model
12 Calibration using spot and futures price data
13 Calibration using option price data
14 Calibrating trees of alternative state variables
Part IV: Putting the Pieces Together
15 Forestry management and valuation
16 Developing a gas field
17 Mothballing an ethanol plant
18 Where to from here?
Bibliography
Full table of contents
Sample chapters and the index can be viewed at amazon.com
Underlying philosophy
All introductions to real options analysis highlight the relationship between
the real options embedded in many capital budgeting problems and the
financial derivatives that make up such a large part of the modern financial
system. The valuation techniques applied to real options originate in the
models used to price financial derivatives. However, there is a fundamental
difference between financial derivatives and real options:
- Financial derivatives are highly standardized, so that a single model
can be used to price a large number of different contracts on different
underlying assets traded on different exchanges at different dates and
in different parts of the world. - In contrast, the real options that arise in the real world will often vary
radically from one problem to another. These differences may arise due
to the particular real options embedded in the projects and the order
in which they can be exercised. They may arise due to different
underlying sources of uncertainty.
Therefore, Real Options in Theory and Practice focuses on building up a general
approach to solving real options problems from the ground up. Rather than
aiming to build a "black box" to solve a small set of standardized real options
problems, it describes the building blocks of any successful real options
analysis and shows how they can be assembled in a way that is appropriate
to the problem being analyzed.
Intended audience
The intended audience comprises practitioners and students in the increasing
number of MBA/MSc-style courses on real options analysis.
In order to make the book accessible to a wide audience, the level of
mathematics has been kept at the level of the binomial option pricing model.
The book is designed to facilitate self-study. As well as being essential if
practitioners are to benefit, this fits in well with the flexible delivery methods
that are increasingly being adopted in post-experience education.
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