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Real Options : A primer

Real Options : A primer. Based on the book by Martha Amram and Nalin Kulatilaka. Introduction. Real options are useful under the following conditions : Contingent investment decisions High uncertainty Need to wait for more information Value lies in future growth options

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Real Options : A primer

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  1. Real Options : A primer Based on the book by Martha Amram and Nalin Kulatilaka

  2. Introduction • Real options are useful under the following conditions: • Contingent investment decisions • High uncertainty • Need to wait for more information • Value lies in future growth options • Flexibility is important • Mid course corrections may be needed as the scenario unfolds • The pay offs to investments are non linear • Conventional tools fail to capture the upside potential and trade offs required in strategic decisions.

  3. Different investment situations • Irreversible investments • Flexibility investments • Insurance investments • Modular investments • Platform investments • Learning investments

  4. Irreversible investments • May need to be delayed • Or broken into stages • Options may exist • These options help truncate losses

  5. Flexibility investments • Build options into the initial design • Eg Flexible Manufacturing System • Eg Time related flexibility • Flexibility is difficult to handle with traditional financial tools

  6. Insurance investments • These are kinked pay offs that cannot be dealt with by traditional tools that handle linear pay offs.

  7. Modular investments • Options can be created through product design • Modular product can be viewed as a portfolio of options to upgrade.

  8. Platform investments • Create valuable follow on investment opportunities.

  9. Learning investments • These generate information that is not otherwise available.

  10. The broad approach • Understand the implications of uncertainty. • Bring insights to other investments. • Focus on total risk. • Consider the full range of outcomes. • Go beyond financial tools which consider only systematic risk.

  11. The Black Scholes Option pricing model • Consider a portfolio of traded securities. • This is called a tracking portfolio. • It has the same pay offs as the option. • Impose no arbitrage condition. • The value of the option equals the value of the portfolio as the stock price moves. • This is the basis for Black Scholes model.

  12. Inputs needed for valuing an option • Current value of underlying asset. • Time to decision date • Investment cost • Strike price • Risk free rate of interest • Volatility of underlying asset • Cash payouts/non capital gains

  13. The building blocks of real options • Real options may have complex pay offs. But the building blocks are simple: • Buy a call option • Write a call option • Buy a put option • Write a put option • Go long on underlying asset • Go short on underlying asset

  14. A call option enables an investor to take advantage of potential good news or high values of the underlying asset. • A put option enables an investor to take advantage of potential bad news or low values of the underlying asset. • A call option is appropriate for a bullish investor. • A put option is ok for a bearish investor.

  15. Challenges in dynamic tracking • Two features of underlying assets cause tracking error : • Costs of tracking • Quality of tracking

  16. Leakages in value • Real assets may generate cash payments similar to a dividend. • Convenience yield may result from holding the asset. • These benefits are available only to the holder of the underlying asset, not to the option holder.

  17. Basis risk • The traded securities in the tracking portfolio may not be perfectly correlated with the value of the option. • The imperfect correlation may be the result of product quality, delivery location, timing, etc.

  18. Private risk • Real options have risks that are not contained in the available set of traded securities. • These private risks are not priced in the financial markets.

  19. Errors/costs in tracking • Infrequent trading • Illiquidity • Costs of coordinating, monitoring and documenting • Infrequent observability

  20. Trade offs • Selecting securities for the tracking portfolio often requires a trade off between a security that is weakly correlated with the underlying asset but with low tracking costs and a security that is highly correlated but with high tracking costs.

  21. Framing a model requires trade offs. • Novice users tend to include too many uncertainties. • Over specifying private risk increases model error. • In many cases, direct modeling of private risk can be avoided because the financial markets have priced the appropriate bundle of risk.

  22. Real options and discipline • The real options approach infuses the strategy creation process with discipline because it : • Expands the menu of resources and strategic alternatives evaluated • Expands the range of markets evaluated • Illuminates the risk of strategic alternatives • Provides consistent comparison of internal projects, contracts and market transactions. • Illuminates the value of and risk in contracts • Focuses on the right questions • Acknowledges the role of luck.

  23. Key insights and perspectives • A higher level of uncertainty increases the value of an option. During uncertainty, an option limits the downside while protecting the upside. • Options may create value but they come at a price. • We should start with a simple and transparent framework and avoid over modelling private risk. If the relevant risks are captured in traded securities, we must use them.

  24. Real options thinking is about expanding the set of feasible alternatives. • Real options encourage us to think far and wide. • Many investment opportunities are rejected because traditional tools ignore the options for follow on investments. • Options to delay, to temporarily shut down, to abandon and to rewrite investment plans in mid stream can significantly increase value.

  25. Look to the financial markets for relevant information. Even if the key focus is private risk, financial markets may provide valuable information. • Don’t aim for too much precision. Strategic investment decisions should be dynamically updated and revised over time. • It is not realistic to pin down the entire investment schedule at any time, only the range of possible outcomes. • We must focus more on getting the problem right rather than on minute details.

  26. The organisational culture must encourage the use of real options. • Trigger mechanisms must be activated when there are changes in the critical value of the underlying tracking asset. • Teams consisting of different people must be involved to identify investment opportunities, develop the necessary quantitative tools and communicate clearly to the top management.

  27. Four steps to using real options • Frame the application • Identify the decisions • What kind of uncertainties are involved? • Set up the decision making rule. • Link to the financial markets • Review for transparency and simplicity

  28. Implement the option valuation model • Establish the inputs • Value the decision using option calculator • Review the results • Redesign if necessary.

  29. Three ways of calculating option values • Partial differential equation approach. The change in the option value is equated with the change in the value of the tracking portfolio. • Dynamic programming – Lay out possible future outcomes and fold back the value of the optimal future strategy. • Simulation approach – Average the value of the optimal strategy at the decision date for thousands of possible outcomes.

  30. Illustration • Mega Pharm wants to fill in a gap in it product line and has proposed to Bio Line that it will invest $ 35 million today for rights to buy Bio Line for $ 200 million in three years. Current market value of Bio Line is $192 million. Is the deal attractive?

  31. Current value = 192 • Strike price = 200 • Time to expiration = 1095 days • Assume Volatility = 30% • Assume R = 5% • We use an option calculator as shown on the next slide.

  32. Illustration • Georgia Properties has an option to buy a property in 6 weeks at $ 82 million. The property generates $ 2.5 milion per month in lease income. At the end of 4 weeks, there will be a single payment to the REIT from rental income. Current price as indicated by a traded REIT is $80 million, volatility is 25% and r= 5%.

  33. A= 80-2.49= 77.51 • X = 82 • R=5%, Volatility = 25% • Time to expiration = 42 days • We use the option calculator again.

  34. Calculation without considering leakage

  35. Illustration • CNet a tech company is planning to acquire Hot Ring. There is an option to acquire 51% of Hot Ring in two years for $ 33.2 million. What is the value of the option? The current value of Hot Ring is $ 30.6 million. The risk free rate of return is 5% and the annual stock price volatility is 45%. No dividend is expected for the next 2 years.

  36. Current value = 30.6 • R= 5%. • Volatility = 45% • Strike price = 33.2 • Time = 2 years = 730 days • Again we use the option calculator

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