Real Options

Chapter 33

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An Alternative to the NPV Rule
for Capital Investments
Define stochastic processes for the key
underlying variables and use risk-neutral
valuation
This approach (known as the real options
approach) is likely to do a better job at
valuing growth options, abandonment
options, etc than NPV

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The Problem with using NPV to
Value Options
 Considerthe example from Chapter 11: risk-free
rate =12%; strike price = $21

Stock Price = $22

Stock price = $20

Stock Price=$18

 Suppose that the expected return required by

investors in the real world on the stock is 16%.
What discount rate should we use to value an
option with strike price $21?
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Correct Discount Rates are
Counter-Intuitive

Correct discount rate for a call option is

42.6%
Correct discount rate for a put option is –
52.5%

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General Approach to Valuation
We can value any asset dependent on a
variable by
◦ Reducing the expected growth rate of 
by s where  is the market price of -risk
and s is the volatility of 
◦ Assuming that all investors are risk-
neutral

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Extension to Many Underlying
Variables
When there are several underlying
variables i we reduce the growth rate of
each one by its market price of risk times its
volatility and then behave as though the
world is risk-neutral
Note that the variables do not have to be
prices of traded securities

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Estimating the Market Price of
Risk Using CAPM (equation 33.2, page 748)
The market price of risk of a variable is given by

  ( m  r )
m
where  is the instantaneous correlation
between percentage changes in the variable
and returns on the market;  m is the volatility
of the market' s return;  m is the expected
return on the market; and r is the short - term
risk - free rate
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Example of Application of Real Options
Approach to Valuing Amazon.com
(Business Snapshot 33.1; Schwartz and Moon)

 Estimate stochastic processes for the company’s

sales revenue and its average growth rate.
 Estimated the market price of risk and other key
parameters (cost of goods sold as a percent of
sales, variable expenses as a percent of sales,
fixed expenses, etc.)
 Use Monte Carlo simulation to generate different
scenarios in a risk-neutral world.
 The stock price is the average of the present
values of the net cash flows discounted at the risk-
free rate.
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Commodity Prices
Futures prices can be used to define the
process followed by a commodity price in a
risk-neutral world.
We can build in mean reversion and use a
process for constructing trinomial trees that
is analogous to that used for interest rates
in Chapter 30

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Example (page 754)
A company has to decide whether to invest
$15 million to obtain 6 million units of a
commodity at the rate of 2 million units per year
for three years.
 The fixed operating costs are $6 million per
year and the variable costs are $17 per unit.
 The spot price of the commodity is $20 per unit
and 1, 2, and 3-year futures prices are $22,
$23, and $24, respectively.
 The risk-free rate is 10% per annum for all
maturities.
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The Process for the Commodity
Price
We assume that this is
d ln(S) = [(t) − aln(S)] dt +  dz
where a = 0.1 and = 0.2

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 Tree Assuming t)=0; Fig 33.1
E J
0.6928 0.6928

B F K
0.3464 0.3464 0.3464

A C G L
0.0000 0.0000 0.0000 0.0000

D H M
-0.3464 -0.3464 -0.3464

I N
-0.6928 -0.6928

Node A B C D E F G H I
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867

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 Final Tree; Fig 33.2
E J
44.35 45.68

B F K
30.49 31.37 32.30

A C G L
20.00 21.56 22.18 22.85

D H M
15.25 15.69 16.16

I N
11.10 11.43

Node A B C D E F G H I
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867

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Valuation of Base Project; Fig 33.3

E J
42.24 0.00

B F K
38.32 21.42 0.00

A C G L
14.46 10.80 5.99 0.00

D H M
-9.65 -5.31 0.00

I N
-13.49 0.00

Node A B C D E F G H I
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867

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Valuation of Option to Abandon; Fig 33.4
(No Salvage Value; No Further Payments)

E J
0.00 0.00

B F K
0.00 0.00 0.00

A C G L
1.94 0.80 0.00 0.00

D H M
9.65 5.31 0.00

I N
13.49 0.00

Node A B C D E F G H I
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867

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 Value of Expansion Option; Fig 33.5 (Company Can
Increase Scale of Project by 20% for $2 million)

E J
6.45 0.00

B F K
5.66 2.28 0.00

A C G L
1.06 0.34 0.00 0.00

D H M
0.00 0.00 0.00

I N
0.00 0.00

Node A B C D E F G H I
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867

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