Further Reading

Introductory corporate finance texts provide more comprehensive discussions of basic valuation concepts in particular, capital budgeting, discounted cash flow techniques, NPV, and the relationship between risk and return. Recommended texts are Ross et al. [Ross+1996] and Brealey and Myers [Brealey+1987].

Hull's book [Hull1997] provides an undergraduate-level overview of derivative securities (including options), the general techniques for their pricing, and derivative markets. Pindyck and Dixit [Pindyck+1992] offer a deeper and more theoretical exposition of option pricing theory together with the econometric foundations of the Black-Scholes and related models.

The seminal paper on option pricing is by Black and Scholes [Black+1973], which explains the original derivation of their and Merton's Nobel Prize winning model. Cox, Ross, and Rubinstein [Cox+1979] provide a much simpler derivation of the same model, using the binomial model and the risk-neutral approach. The Black-Scholes model has many variations that have similar analytic solutions. The most relevant ones are discussed by Margrabe [Margrabe1978] and Carr [Carr1988]. Margrabe derives a formula for the option to exchange two risky assets, of which Black-Scholes is a special case. This formula can be used when the exercise cost of an option is also uncertain [Erdogmus2001A]. Carr provides a comprehensive discussion of Margrabe's formula and other, more complex variations, including compound options. Kumar [Kumar1996] provides a compact discussion of the impact of volatility on option value.

Sundaram [Sundaram1997] gives the best exposition of the binomial model and risk-neutral valuation. Smith and Nau [Smith+1995] explain the relationship between option pricing and decision trees, and demonstrate how the two models together can account for both market and private risk. These two articles are highly recommended for those interested in the practical application of option pricing to real assets.

Many excellent, high-level articles exist that discuss the use of option pricing theory in valuing options on real assets [Amram+1999; Luehrman1998; Myers1984]. Myers, who originally coined the term real options, explains how the real-options approach links strategy and finance. Texts that focus on applications of real options include Copeland and Antikarov [Copeland+2001] and Amram and Kulatilaka [Amram+1999]. Further applications can be found in two books by Trigeorgis [Trigeorgis1999; Trigeorgis1994]. The older of these is a self-contained textbook, and the more recent is an edited collection focusing mostly on applications.

Applications of real options to information technology in general and software development in particular have been addressed in many articles. Those addressing investment decisions in software development include [Erdogmus2001A; Erdogmus2001B; Favaro+1999; Boehm+2000; Erdogmus+1999; Favaro1996]. Sullivan et al. focus on applications to software design [Sullivan+1999], and the book by Clark and Baldwin focuses on applications to modularity in general in the context of hardware design [Baldwin+1999]. General applications to information technology investments are also available [Benaroch+1999; Benaroch+2000; DosSantos1991; Taudes+2000].