Session 21: The Essence of Real Options
Real Options Valuation
In this session, the speaker talks about the application of option pricing models in valuation and how it can be used to value real businesses. The speaker explains why investments in certain businesses can be thought of as options and what implications this has for investors.
Introduction to Real Option Valuation
- Traditional discounted cash flow valuation underestimates the value of assets with embedded options.
- There are three types of options embedded in assets:
- Option to delay investment
- Option to expand
- Option to abandon
- Real option valuation is an augmentation, not an alternative, to discounted cash flow valuation.
Understanding the Value of Options
- A simple illustration shows that breaking down an investment into two steps can make a bad investment good.
- The key words that drive the value of real options are learning and adaptive behavior.
Example: Valuing an Oil Company
- Traditional discounted cash flow models miss out on the capacity for learning and adaptive behavior.
- An oil company's production is affected by changes in oil prices, which they have the option to adjust based on observation and adaptation.
Implications for Investors
- When valuing businesses using option pricing, a premium should be attached to traditional discounted cash flow evaluations.
- Real option valuation provides investors with a more accurate understanding of the potential value of certain investments.
Identifying Real Options
In this section, the speaker discusses the characteristics of an option and when to use option pricing models.
Characteristics of an Option
- An option is a derivative security that derives its value from something else.
- An option has contingent payoffs; something has to happen for your cash flow to pay off.
- An option has limited lives.
Payoff Diagrams
- A call option gives you the right to buy an asset at a fixed price. The payoff diagram will have a kink at the strike price, with potentially unlimited profits above it and limited losses below it.
- A put option is like holding a mirror up to those same cash flows. If the value falls below the strike price, you lose money, but if it exceeds it, you lose what you paid for the put.
Determinants of Option Value
- There are three determinants related to the underlying asset:
- The value of the underlying asset
- The variance in that value
- Whether or not it pays dividends
- Two variables relating to the option matter:
- The exercise price itself
- Whether or not there is exclusivity in exercising the option
Significance of Economic Value
- Exclusivity is key in determining whether or not an option has significant economic value.
- Less exclusivity means less value in the option.
- If there is no exclusivity, there is no option value.
Overall, this section provides an introduction to identifying real options and understanding their characteristics and determinants of value. The speaker emphasizes the importance of exclusivity in determining whether or not an option has significant economic value.
Understanding Option Pricing Models
In this section, the speaker discusses the basics of option pricing models and the principles that govern them.
Principles of Option Pricing Models
- The two basic principles that govern how option pricing models work are replication and arbitrage.
- To use replication arbitrage, you need to be able to buy and sell the underlying asset, buy and sell the option, and borrow and lend at the risk-free rate.
- The Black-Scholes model is a simple option pricing model that makes restrictive assumptions about variables such as European options, fixed variance of underlying assets over time, and no jumps in prices.
- The Binomial model is less restrictive but requires more information to specify prices at every branch of the binomial model.
Real Options
- Most real options have changing variances over time and require early exercise.
- To apply options in valuation, there are three basic tests you must meet:
- Check for an option embedded in an action
- Check for exclusivity of significant option value
- Check if you can trade on the underlying asset and the option because only then can the option pricing be applied.
Note that timestamps were not available for some parts of this transcript.