Question

Explain the six levers of real options and how they differ from financial options. Using conventional options notation, outline and write the payoffs for any three common real options ‘embedded’ in corporate investment projects.

Answer 1

Real Options: Real options are a right but not an obligation to make a business decision. The concept of a real option is crucial to the success of a business as the ability to choose the right business opportunity bears a significant effect on the company’s profitability and growth. A real option allows the management team to analyze and evaluate business opportunities and choose the right one.

Six Levers of Real Options:

1. Period for which opportunity is valid (+)

2. Unpredictability of expected cash flows (+)

3. Present value of expected cash flows (+)

4. Value lost over duration of option (-)

5. Yield of a riskless security (+)

6. Present value of fixed costs (-)

(+) rises option value and (-) lowers option value

Differences between Real Options and Financial Options:

Real Options	FinancialOptions
Short Maturity (usually months)	Longer maturity with several years
Volatality sufficiently stable	Diminishing Volatality
Underlying variable is equity or asset price	underlying variables are free cash flows driven by competition,demandandmanagement
No possibility to manipulate and control option value	Managerial decisions and flexibility increase option value
Numerical accuracy more important	Framing the option case more important