KIT

Question 1

BSOP assumptions

Answer 1

1. BSOP to estimate real option values
2. it is developed for financial products, not physical products
3. assumes that a market exists to trade the underlying project or asset without restrictions, within frictionless fin and product markets
4. volatility and risk of underlying asset can be determined accurately and readily
5. unlike financial assets which have history of underlying asset’s volatility, this is prob-ly not going to be the case for real options. for large, one-off projects, there would be little or no historical data available
6. Volatility in such cases should be estimated through simulations, monte carlo. with the need to ensure that model is developed accurately and data input used to generate outcomes reasonably reflects what is likely to happen in practice

Question 2

BSOP assumptions 2

Answer 2

1. real option is EU style option, ca nbe exercised on the date when the option expires. Sometimes more strategic sense to exercise the option earlier!
2. the real option represents American style option which can be exercised before expiry, therefore BSOP model may underestimate the true value of an option

Question 3

BSOP assumptions 3

Answer 3

real options assume that any contractual obligations involving future commitments will be binding and fulfilled
there is no risk of non-fulfillment of commitment to purchase project at the start of year 3 for amount X
BSOP model does not take account of behavioral anomalies which mb displayed by managers when making decisions