2.1 Real Options Flashcards
- What are the steps in valuating flexibility?
1: Identify Options
2: Value the Flexibility
- What are the conditions when identifying options?
1: News will arrive in the future
2: When it arrives, the news may affect the decision
- “Phases”, “Scenarios”, “Strategic Investment” might be clue for ___
Real Options
- Checklist of frequently encountered options
- Growth option
- Abandonment option
- Option to expand or contract scale
- Timing option
- Option to switch (inpouts, outputs, processes, etc.)
- Timing Options / Option to defer
• Flexibility over the timing of the investment. Can wait to invest
- Timing Options / Option to defer. Important in:
• Real estate, technology
- Staged Investment
Option to reevaluate and/or abandon project at any time
- Staged investment important in
R&D, energy, start-up ventures
- Option to expand/contract scale
If market conditions change, the firm can expand/contract the fraction (for example the production scale)
- Option to expand/contract scale important in
Natural resources,
fashion, real estate,
consumer goods
- Option to abandon
If market conditions decline, management sells off assets.
Like a put option. Can, but don’t have to get rid off…..
- Option to abandon important in __
Capital-intensive industries, new product introduction in uncertain markets
- Option to switch
Management can change product mix or switch inputs
- Option to switch important in
Volatile markets with shifting preferences, energy companies
- Growth options
Allows for follow-up investments if prices or demand changes
- Growth options important in
High tech; industries with multiple product generations
- Multiple Interaction Options + important in?
Project involve a collection of various options – both put and call types.
Important in many industries
- Different real options
1: Timing option (option to defer)
2: Staged Investment
3: Expand/Contract Scale (alter operating scale)
4: Option to abandon
5: Option to switch
6: Growth options
7: Multiple Interacting Options
- In what ways can we value an option
1: Binomial trees
2: Black-Scholes
- What strategies can we use when creating binomial trees?
1: Replicating portfolio
2: Risk Neutral Valuation
- Horizon is a new start-up, and plans to enter 9 new markets in year 2. The key uncertainty is the price markup on transport. its a 50% chance that it’s 25% and a 50% chance its 15%. Assume losses of $ 5.9 million per market then. (You want high markups). If the markup is 25%, they will be able to generate 13,7 per market. Cost of Capital is 16%. Show the value:
One tree up gives 13,7 * 9 = 123
Tree down gives 0 (Investors are not passive, so they will not enter 9 markets)
Value: [0,5 * (9 * 13,7)] / 1,16^2 = 46
- When can you use the decision tree approach?
When you are sure you are facing a zero-beta project
- What discount rate are used with decision trees
Can use Risk-Free Rate or the firms Cost of Capital
- How can you simplify a project with two different phases – and how can you value the lower bound?
Simplify by separating the DCF-analysis of them.
Add the DCF-values together. This is a benchmark for the lower bound
So you only go with Phase 2 if it has positive NPV
- What is risk neutral pricing
- Assumption that all investors are risk-neutral
- This means that all financial instruments yield the same return = risk free
- Then compute the probability that ensure no arbitrage
- What are some practical issues with real options?
1: What volatility to use
2: Interpretation
3: Which method should be used
- How to find the volatility?
1: Informed Guess
2: Use data available
- How to interpret
Since we use simplified models, results needs to be taken with a grain of salt.
Put complexity back into the model with:
1: Sensitivity analysis
2: Conditioning and qualifying of inferences
- Consider two firms that could both do the same project. Both can execute the project early, or they could wait. How much is the option worth when there is a competitor?
• Check both value of investing immediately and
- Competitor enters now
- Competitor enters later
• Do the same calculating the option value of waiting when
- Competitor enters now
- Competitor enters later
Then put payoffs in a matrix and view it as a game. Solve for the Nash Equilibrium
- Under the BS assumptions, the stock price follows a ____
Geometric Brownian motion (GBM)
- How do we get the annual volatility?
- Estimate from daily stock changes
* Ignore days without much trading, i.e. weekends or holidays (concentrate on trading days)
- What does ARCH/GARCH do?
Helps us predict tomorrow’s variance conditional on today’s.
