Risk

A real option itself, is the right — but not the obligation — to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively. They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments.

Determinants of option values: Uncertainty (or project risk)

– Option value increases with the degree of uncertainty; the greater the uncertainty, the better is the ability to wait and yet retain the right to an action such as investment in a project

• The time to expiration – Option value increases with time to expiration

• The interest (or discount) rate– Option value decreases if there is an increase in the interest or discount rate, as future cash flows from exercising the option are discounted heavily

• Exclusivity– Option value is higher if the benefits from exercising the option accrues exclusively to the option’s owner; it is lower if the benefits have to be shared with others

Strategies are produced by sequentially entering into, exercising, abandoning or selling options • Options can be incremental options or flexibility options. Incremental options are simple calls or puts – Call options that define strategies can be reversed or sold (e.g., selling a JV share to the JV partner) – Flexibility options facilitate strategic change (e.g., producing oil and gas while investing in green technology) .The process starts with a firm’s management recognising the potential to gain in the future by gaining access to an asset or developing a technology (shadow option) and then making a small investment to secure preferential access to the asset or taking a step towards...