Use of Real Options Theory in Financial Modeling

Introduction

A real option is the right but not the obligation to buy or sell an underlying asset or contract a capital investment under agreed conditions. It is the option to undertake some business decision such as opportunity to invest in or sell shares of a company listed in the stock exchange. Simply put, an opportunity to invest is a call option while an opportunity to sell is a put option. Real Options apply the process of decision making under uncertainty, which basically uses assumptions underlying investors’ projections. In addition, Real Options Valuation is adopted to assist investors to determine where to best invest their money in. It enables investors to forgo certain investment for better ones.

Real Options Theory in Financial Modeling

Real options investment puts into consideration managerial flexibility in adapting to dynamic changes in financial, economic, corporate, and strategic environments. If utilized correctly with complementation of traditional approaches, it may provide a robust analysis in understanding a projects true strategic value (Mun, 2006, Pg 391). These options should specifically be used for businesses with key characteristics that are limited, and operate in a market where changes and uncertainties are most evident. However, use of real options may be irrelevant in businesses that have many key characteristics. Changing trends in product demand and supply create uncertainties that enable use of real options due to investment volatility created by shifting trends in demand and supply.

Financial analyst need to come up with projected outcomes by adjusting the outcomes with respect to uncertainties facing the investment. Generally, volatility of financial options is directly proportional to value of outcomes, thus, the lower the volatility of the underlying asset, the lower the value of outcome. Volatility is the uncertainty with which the change in value over a certain period of time is estimated. The outcomes are modeled using methods such as capital budgeting, net present value and discounted cash flows. Therefore, real option analysis enables investors to obtain tangible options and hedge the risk so as to take advantage of the upside ( Mun, 2006, pg 393)

Options of investment

  • The option to terminate an investment before the end of its planned lifespan: This enables investors to avoid monetary losses on investment that turn up to be financially unsuccessful later on after the investment has been made.
  • The option to adopt a greater degree of flexibility into a company’s operations to increase the net present value of an investment and reduce costs being incurred; for example, a manufacturing company may use flexible techniques that lead to varied net present value.
  • The option to expand in new or ongoing existing markets: This is the case if a project being undertaken has the potential for growth and venture in new investments with the projections of increased returns.
  • The option to postpone or delay acceptance of an investment for appropriate periods, in response to changes in the competitive general market conditions: In this case net present value of investment is rendered favorable with respect to the most probable timing
  • Real option has become effective in the investment world where investors used to apply the traditional method of ‘fail an option first then apply other options later’. Unlike traditional methods, real options use advanced techniques to handle uncertainties, which have been placing the most serious problems on investment industry. In this case, real option helps business executives to incorporate uncertainties, as well as decision-making process to undertake successful investment strategies (Mun, 2006, Pg 391).

Risk Implication to Investors

The decision to invest on the financial options whose outcomes have been projected depends on the type of investor; risk averse, risk taker or risk neutral. Investors who are risk takers are more likely to invest in financial options with highest projected outcomes given its high level of volatility or risk involved. Here, real options are essential in explaining the variation between stock market prices of businesses and the intrinsic value of the same businesses listed in the stock exchange.

Criteria to relevance of real option theory

  • Existence of uncertainties to enable valuation of the option.
  • Strategic flexibility of the management on projections.
  • Credibility of management to execute the options appropriately.
  • Existence of a financial model that is applicable to the options.
  • Impact of uncertainties on the results of financial models and decisions on the project (Mun, 2006, Pg 392)

Underlying options are modeled in terms of option characteristics, spot price, volatility, and options terms. Spot price is current value of the projections while option term refers to the time value of the option – time that an option takes for it to mature or expire. In this case, the real options theory is a flexible investment application that tailors solutions of businesses to fit a particular business problem. It mainly applies adaptation of standard black scoles formula by customizing analytical tools (Alleman, 2002, pg 84).

Financial modeling focuses on theories that come up with expected value based on general analysis of environment, real world situations in particular. This is a single investment strategy used in final options in decision-making process. Generally, the managerial decision making process consist of different stages of implementation. In this case, the probability of a positive outcome changes from one option of investment to another.

In traditional application, the likelihood of success arises after several trials among the differing options, unlike the first or second option whose likelihood of failure is the same as that of success. Moreover, decision making process in financial modeling of projected investment value looks at the wide variety of options to invest in; the option choice on the most viable investment option whose projections are satisfactory.

Real options may also apply mathematical structures that solve business problems by finding solutions to a set of simultaneous linear equations; these equations enable projection of the balance sheets and income statements for future years. Organizations that use of spreadsheets may also apply it to find solution of the model, and these can particularly be done by feeding relevant accounting entries in the excel model (Benninga, and Czaczkes, 2000, pg 57).

Real options in financial modeling in the business world simply chooses to apply the use of spreadsheet features such as, scenario manager, database, data tables Operations and data analysis add-in to project future outcomes. This use simplifies real option theory that has always been viewed as non-applicable in the real business world. This has been mainly because of the fact that real option is characterized by the use of complex formula.

Cost Benefit Analysis of Real Option Theory

Use of real options theory is considered to achieve high returns in respect to cost benefit implication when it is applied on investment of financial options that have long time to maturity. High volatility rates with the implication that the underlying assets are very risky also renders use of real options valuable due to its high return (Ehrhardt and Brigham, 2009, pg 388). The costs associated with financial analyst may be high and irrelevant to the simple investment that may otherwise use spreadsheets to project cash flows of coming years.

Application of binomial model requires the use of an event lineup to enable managers know possible outcome results of each option being invested to give similar environment and influencing factors. Investment decision makers then work backward from projected outcome results after the probable option implementation to determine the present value of investment option. These calculations enable investors get tangible information on possible outcomes on the various options, thus selecting an option with the best and most favorable returns.

Alternative Financial Models

Other financial models include the option to exchange an asset for another, the option to purchase the minimum or maximum of two or more assets and an option of an average of several assets (Brigham and Daves, 2009, Pg 508). Options can basically be classified into two with respect to the period to which the option is exercised. The classifications are American options and European option, whereby, American options can be exercised any time before their expiration while the European options can only be exercised at maturity

Real options with which investors need to make a decision, given the fact that all options are available, are usually under high uncertainty. Underlying assets in which investors are troubled in making a decision have similar limiting and influencing factors in the general market although there are factors that are specific to an option (Lee and Lee, 2006, pg 556).

Limitations of Real Options Theory

  • Real options analysis is rarely used practically because of its theoretical focus; it is more of an academic process that focuses more on theory rather than practical application in real investments.
  • Real option analysis incorrectly increases the value of projections to make them justified. This may cause adverse effects in the cases where investments have no strategic options and flexibility.
  • Tendency for real options to choose higher risk projections due to the high option values linked to higher volatility may be misleading in cases where there ere low option values.

Financial modeling option pricings mainly focus on application of arbitrage in investment market. This can only be done by professional financial analyst with tangible information on stock markets. In the case where there is no arbitrage, two assets with similar payoff need to have the same price. Market participants make risk-less profits through selling assets that are more expensive then reinvesting the proceeds in buying cheaper assets given the fact that they have same payoffs.

In real options, the arbitrage is done between the underlying asset with lower returns but lower risks, and options with high returns in combination with its high risk. In this case, risk averse investors will tend to prefer options with lower risks while risk takers may prefer high-risk investors. Moreover, real options need to be continuously projected to give information of market changes before market prices of the options could be reproduced by trends in the markets.

Conclusion

Every corporate business is an investment process where managers exercise decision making from a wide range of investment options. These choices may enable growth or decline in the value of a corporate business. Despite this decision-making crisis, many companies do not apply options theory to investment, partly because these real options are highly complex. The complexity of real options can however be simplified through application of simpler and more relevant methods such as simultaneous linear equations in the normal and common business environment.

References

Alleman, J. (2002). The new investment theory of real options and its implication for telecommunication economics. NY: Springer.

Benninga, S. and Czaczkes, B. (2000). Financial Modeling. MA: MIT Press.

Brigham, E. F. and Daves, P. R. (2009). Intermediate financial management. OH: Cengage Learning.

Ehrhardt, M. C. and Brigham, E. (2009). Corporate Finance: A focused approach. OH: Cengage Learning.

Lee, C. F. and Lee, A. C. (2006). Encyclopedia of finance. NY: Springer.

Mun, J. (2006). Modeling Risk: Applying Monte Carlo simulation, real option analysis, forecasting and optimization technique. NJ: John Wiley and Sons.

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