Final Remarks


Academics and practitioners frequently debate the suitability of the financial options analogy, and the techniques developed to price these options, to the valuation of real-options scenarios. The main differences between financial and real options are summarized in Table 43.4.

Two points are important to keep in mind here.

First, the existence of trading markets and assumptions about their efficiency, completeness, and liquidity are critical for financial option pricing techniques. These techniques are designed to treat risks that can be priced in such markets. The suitability of a specific option pricing technique to value a real-options scenario may thus depend on the nature of the uncertainty being treated and how close to the market the underlying assets are. In software development projects, where private risk is an important factor, the financial options analogy may be weak.

In cases where the financial option real option analogy is weak, the option values yielded should thus be treated as idealized values computed under the assumption of the existence of a market equivalent that reasonably closely tracks the risk being tackled. Fortunately, sometimes risks that seem purely private at first can be market-priced, thanks to an expanding and vibrant securities market in the technology sector. For example, it was difficult to model the market risk associated with the growth option that Netscape had when it introduced the first browser, simply because it was the first of its kind and there weren't yet any other Internet companies on the market. This situation has changed. Netscape was rapidly joined by other Internet companies, with the result that there are now several Internet stock indexes that track the market risk and volatility associated with Internet investments. Another example is provided in [Erdogmus2001B]. For further discussion of the analogy between financial and real options and the limitations of this analogy, see the last sidebar in [Amram+1999].

Second, like all forecasts, the numbers used in options calculations will be more or less precise. The final numbers obtained are as good as the estimates used in their calculation. Where these estimates are unreliable, option values can still provide much insight if they are used in an informed manner, especially along with comparative, sensitivity, and scenario analyses.

Table 43.4. Financial Options Versus Real Options
Financial Options Real Options

Complete markets. Payoff structure can be emulated by a replicating portfolio.

Incomplete markets. Payoff structure often cannot be practically emulated by a replicating portfolio.

Traded asset. The underlying asset is traded in the financial markets.

Twin security. The underlying asset is not traded; instead, a proxy, or twin security whose value is correlated with the underlying asset, must be assumed. This also applies in DCF and NPV.

Observed current price. The current price of the underlying asset is observed.

Lack of an observed current price. The current price of the underlying asset is not observed. It must be estimated as a PV from a stream of future cash flows.

No discount rate. A discount rate is not needed to value the option because of the existence of an observed price and the use of replication and no-arbitrage assumptions.

Discount rate needed. A discount rate is often needed to calculate the PV of a stream of future cash flows as a substitute for the current price of the underlying asset.

No interaction. Financial options are self-contained contracts. They don't interact.

Extensive interaction. There are often complex interactions among different real options within a project or even across different projects. The behavior of one option affects the value of the other.

Sources of uncertainty constrained. Financial options involve one or two uncertain underlying assets.

Multiple sources of uncertainty. Real options often involve multiple underlying assets or assets with multiple sources of uncertainty.

Single ownership. Financial options have defined ownership.

Shared ownership. Real options are often shared among competitors. A company's exercise of a real option may kill or significantly undermine the same real option for a competitor and vice versa.

Value leakage. The holder of a financial option may be subject to the loss of benefits while waiting to exercise the option because of dividend payments or convenience yield that are available to the holders of the underlying asset, but not to the holders of an option. The rate and pattern of this can be estimated using historical data or using industry conventions.

Competition, partnerships, and sharing. The holder of a real option may be subject to the loss or amplification of benefits while waiting to exercise the option because of the actions of competitors and partners and shared ownership, all of which may be very difficult to quantify.



Extreme Programming Perspectives
Extreme Programming Perspectives
ISBN: 0201770059
EAN: 2147483647
Year: 2005
Pages: 445

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