AC6101 Lecture 7 - Real Option Analysis

AC6101
Project Finance
Real Option Analysis
Brief review of basic option principles
What is an option?
Definition
A contractual arrangement giving the owner the right, but not the
obligation, to buy or sell an asset, at a given price at some time in the
future.
Financial Options
- give the holder the right to buy/sell a traded asset –
shares/commodities/currencies
Real Options
- gives the holder the right to make an investment decision
2
Option Terminology
• Call
• Put
• Buy - Long position
• Sell – Short position
• Key Elements
– Exercise or Strike Price
– Premium or Price
– Maturity or Expiration
3
Long and Short Positions
• The buyer of the option contract is referred to as the
Long party.
• The seller of the option contract is referred to as the
Short party.
• The seller of an option contract does not enjoy the
same discretionary right as the buyer.
• The option seller receives an option price (premium),
and in exchange, assumes the obligation to satisfy
the buyer’s exercise rights if the option is exercised.
4
Market and Exercise Price
Relationships
• Options, like other financial instruments, may be traded on organised exchanges.
• The price at which the option is traded is linked to the intrinsic value of the option.
• The intrinsic value of an option is the pay-off that would be
received if the underlying were at its current level when the option expires
• Higher the intrinsic value, the higher the price it will command.
In the Money - exercise of the option would be profitable.

Call: market price of underlying>exercise price
Put: exercise price>market price
Option has intrinsic value
Out of the Money - exercise of the option would not be profitable.
Call: market price<exercise price
Put: exercise price<market price
Option has no intrinsic value
At the Money - exercise price and asset price are equal.

Option has intrinsic value
5
American vs. European Options
• American - the option can be exercised at any
time before expiration or maturity.
• European - the option can only be exercised
on the expiration or maturity date.
• Not related to market option is traded on
6
Types of Financial Options
• Stock Options
• Index Options
• Futures Options
• Foreign Currency Options (tend to be
European Options)
7
Financial Option Markets
• OTC
- non-standardised option terms – can be tailored to buyers req’s
- cost is greater than traded options
- not exchange tradable
• Exchange Traded Stock Options
- standardised maturity date, contract size (100 shares CBOT, 1000 shares LIFFE), exercise
price
- limited range of options e.g. may be 4 puts & 4 calls available for Microsoft shares.
- relatively short term - maturity of up to a few months
- Traded on specialist exchanges e.g. CBOT, LIFFE
8
Option Payoffs and Profits at
Expiration - Calls
Notation
Stock Price = ST Exercise Price = K
Payoff to Call Holder
(ST - K) if ST >K
0 if ST < K
Profit to Call Holder

Payoff - Purchase Price (premium)
Payoff to Call Writer

- (ST - K) if ST >K
0 if ST < K
Profit to Call Writer
Payoff + Premium
9
Profit Profiles for Calls
Profit Call Holder
Call Writer
Stock Price
10
Payoffs and Profits at Expiration - Puts
Payoffs to Put Holder
0 if ST > K
(K - ST) if ST < K
Profit to Put Holder

Payoff – Premium
Payoffs to Put Writer

0 if ST > K
-(K - ST) if ST < K
Profits to Put Writer

Payoff + Premium
11
Profit Profiles for Puts
Profits
Put Writer
Put Holder
Stock Price
12
Option Pricing
Factors that influence the option price.
Note: we’ll come back to these factors when pricing real options
Current price of the underlying asset. (S)

• Option price will change as the price of the underlying asset
changes (as quoted on a relevant market).
• As price of underlying asset rises, the price of calls (puts) rises
(falls).
Exercise price (K)
• The exercise price is fixed for the life of the option.
• The lower the exercise price, the higher the price of a call option (as
the call option has a better chance of being in the money).
• Put options – Higher the exercise price, the higher the price of the
put option.
13
Option Pricing
Time to expiration of the option (T)

• An option is a wasting asset – after expiration date it has no value.
• The longer the time to expiration, the higher the option price (calls and
puts).
• As the time to expiration decreases, less time remains for the
underlying asset’s price to rise (call) or fall (put), and therefore the
probability of a favourable price movement decreases.
Expected price volatility of the underlying asset over the life of the
option.
• Investors are willing to pay more for options where the underlying
asset displays high volatility (measured by standard volatility or
variance).
• High volatility increases the probability of a favourable price
movement.
14
Option Pricing
Risk free interest rate over the life of the option (r)
• Buying the underlying asset ties up funds.
• Buying an option on the same quantity of the underlying
asset makes the difference between S and C available for
investment at an interest rate at least as high as the risk
free interest rate.
• Higher short term interest rates make call (put) options
more (less) attractive than direct purchase (sale).
• Financial & Real Options can be priced using the Black-

Scholes equation.
15
Real Options
Traditional DCF approaches cannot properly
capture the company’s flexibility to adapt and
revise later - decisions in response to
unexpected market developments. Traditional
approaches assume an expected scenario of
cash-flows and presumes management’s
passive commitment to a certain static operating
strategy.
16
Real Options
The real world is characterized by change,
uncertainty and competitive interactions =>
– As new information arrives and uncertainty
about market conditions is resolved, the
company may have valuable flexibility to
alter its initial operating strategy in order to
capitalize on favorable future opportunities
or to react so as to mitigate losses.
– This flexibility is like financial options, and
is known as Real Options.
17
Examples of Real Options
• Option to invest in a new technology-
based service/product, as the result of a
successful R&D effort.
• The option to shut down a mine mid-

project.
• The patent and other intellectual property

owned by a firm.
Real Option Analysis in Project Finance
• An approach to capital budgeting that relies on
option pricing theory to evaluate projects.
• Real options approach is intended to
supplement, not replace, capital budgeting
analyses based on standard DCF methodologies.
• Insights from option based analysis can improve
estimates of project value.
• Real options analysis has potential, in certain
cases, to significantly enhance project
management.
Motivation for Real Options
Approach
• Traditional capital budgeting effectively approaches
consider investments as bonds or equities.
• Often times firms fail to invest in a valuable project
because imbedded options are overlooked.
• Many strategic corporate investment proposals bear a
strong resemblance to a call/put option.
• Ignoring option-like features of important investment
projects can lead to poor decisions.
• Options approach focuses on the importance of
investment timing - committing funds at the ideal time.
Asset-in-Place vs. Options
A.
A. This
Thisisisnot
notan option..
anoption B.
B. This
Thisisisan option..
anoption
Cash flow Cash flow
Good news Invest
Invest Good news

Bad news Don’t Invest
Cash flow Cash flow
Cash flow Cash flow
Good news Invest
Don’t Invest Bad news
Bad news Cash flow Don’t Invest Cash flow
– Standard DCF techniques treat projects as shown in Figure A.

– For some projects this may be an inadequate representation.
– Sometimes managers have the option to wait and see what happens regarding one or more sources of uncertainty before making a decision.
– An efficient capital market would not place the same value on both of these projects.

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In the Money - exercise of the option would be profitable.

At the Money - exercise price and asset price are equal.

Profit to Call Holder

Payoff to Call Writer

Profit to Put Holder

Payoffs to Put Writer

Profits to Put Writer

Current price of the underlying asset. (S)

Time to expiration of the option (T)

• Financial & Real Options can be priced using the Black-

• The option to shut down a mine mid-

• The patent and other intellectual property

Invest Good news

Bad news Cash flow Don’t Invest Cash flow

– Standard DCF techniques treat projects as shown in Figure A.

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