Real Options Flashcards
Real options
are option to modify capital investment.
Definition:
A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities
What are real options?
The real options approach is viewed as a problem of optimization of a real asset (a piece of equipment, a building, land, a project, etc.) under uncertainty, given the available options.
Why Real Options are not measurable with the same accuracy as financial options ?
Because the formulas applicable to the Financial option is not appropriate for real options . Thus, other methods , e.g., decision-tree analysis with recognition of probabilities and outcomes and simulations, are used in conjunction with discounted cash flow methods.
Types of real options
1 - Abandonment of a project entails selling its assets or employing them in an alternative project. (Lap7)
2 - the option to delay
3- the option to expand
4 - the option to scale back
5 - the flexibility option to vary inputs, for example , by switching fuels.
6 - the capacity option to vary output, example …..
7 - the option to enter new geographical market
8 - the new product option
Why real option is referred to as “real” ?
because it typically references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financial instrument.
Real options differ thus from financial options contracts since they involve real (i.e. physical) “underlying” assets and are not exchangeable as securities.
Risk tolerance
Risk tolerance is the acceptable degree of variability in returns.
1) A company with a high risk tolerance is willing to risk big losses for the chance at
big gains.
2) A company with a low risk tolerance will avoid seeking big gains in order to avoid
the possibility of big losses.
The certainty equivalent
The certainty equivalent is the guaranteed return that a company would accept over taking a risk on a higher, but uncertain return.
1) The certainty equivalent specifies at what point the company is indifferent to the choice between a certain sum of money and the expected value of a risky
investment.
