Real Options Analysis

Real Options Analysis involves applying the mathematical techniques found in financial options to assess the best course of action to be taken when faced with a real-life decision. For example, R&D managers can use Real Options Analysis to help them determine where to best invest their money in research. It can be used in conjunction with Monte Carlo analysis.

The distinctive feature of this technique is that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, and managements ability to respond to the evolution of these parameters. The uncertainty is modeled as the volatility of the project value, and managements ability to respond is modeled as an option to contract (an American put option), abandon (also an American put), expand or extend the project (both American call options). For real world projects, often also switching options, composite options or rainbow options are required, which makes a real options analysis technically more difficult than its alternatives. An additional technical difficulty is in estimating the volatility of the project.

Because real options analysis takes into account responding to uncertainty, the real options value of a project is always higher than the net present value, especially in projects with huge uncertainties (higher volatility of the underlying leads to higher value of an option). This is because net present value, which is still the most frequently used technique to date, can only model responding to uncertainty by using precommitted management decisions to mutually exclusive scenarios, and then equating total project value to the scenario that has the highest value.

The technique does involve attempting to predict the future, and as such the quality of the output will only ever be as good as the quality of the inputs, which by their nature are sketchy. This is also valid for net present value analysis, but this technique does not require volatility information. Opinion is therefore divided as to whether Real Options Analysis provides genuinely useful information to real-world practitioners.