Lecture Notes in Management Science (2012) Vol. 4: 169–178 4th International Conference on Applied Operational Research, Proceedings © Tadbir Operational Research Group Ltd. All rights reserved. www.tadbir.ca ISSN 2008-0050 (Print), ISSN 1927-0097 (Online) Differences between financial options and real options Tero Haahtela Aalto University, BIT Research Centre, Helsinki, Finland [email protected] Abstract. Real option valuation is often presented to be analogous with financial options valuation. The majority of research on real options, especially classic papers, are closely connected to financial option valuation. They share most of the same assumption about contingent claims analysis and apply close form solutions for partial difference equations. However, many real-world investments have several qualities that make use of the classical approach difficult. This paper presents many of the differences that exist between the financial and real options. Whereas some of the differences are theoretical and academic by nature, some are significant from a practical perspective. As a result of these differences, the present paper suggests that numerical methods and models based on calculus and simulation may be more intuitive and robust methods with looser assumptions for practical valuation. New methods and approaches are still required if the real option valuation is to gain popularity outside academia among practitioners and decision makers. Keywords: real options; financial options; investment under uncertainty, valuation Introduction Differences between real and financial options Real option valuation is often presented to be significantly analogous with financial options valuation. The analogy is often presented in a table format that links the Black and Scholes (1973) option valuation parameters to the real option valuation parameters. Table 1 illustrates this analogy. All too often, however, the differences between the two approaches are not discussed thoroughly. Furthermore, some of 170 Lecture Notes in Management Science Vol. 4: ICAOR 2012, Proceedings these arguments are rather academic by nature and do not reflect the practical concerns of real option valuation. Discussion about the interpretation of the calculated result and its theoretical correctness may be irrelevant, because the underlying assumptions often contradict the reality quite harshly. Table 1. Analogy between financial and real options. Financial option Real option Value of the underlying asset, i.e. Present value of project’s or investment’s S stock price cash flows Amount of money to be invested or X Exercise (strike) price received in launching (exercising) the action (option) T Time until the option expires Time until the decision must be made Standard deviation (volatility) of Uncertainty about the future value the value of the underlying asset (probability distribution) R Risk-free rate of interest Risk-free discount rate Dividends paid out by Dividend like cash outflows or inflows of D the underlying asset project over its life-cycle Many real option valuation procedures derived from the financial option valuation have the problem that they do not necessarily follow the same assumptions. For example, financial option values may never be negative, whereas some real options may have negative underlying asset values. If the valuation method does not take this into account, it may provide strange and misleading results. Another significant difference is that information on financial option valuation parameters is often easily available for everyone in the markets. This does not hold for real options, and this ambiguity should be considered both in the practical valuation and in interpreting the calculated results. Also, the length of the investment periods is typically different; as a result, uncertainty changes (usually reduces) more during the real option investment. Table 2 is not a comprehensive listing of the differences but instead shows certain elementary issues with several example references for each topic. Table 2. Differences between the financial and real options. Financial option Real option References Short maturity (usually Longer maturity with several Mun (2002); Triantis months) years (2005); Brach (2003) Time-varying, usually Brach (2003); Majd & Volatility sufficiently stable diminishing, volatility Pindyck (1987) Rather mean reverting in the Laughton & Jacoby Follows better gBm long run (1993) T Haahtela 171 Financial option Real option References Underlying variables are Underlying variable is equity free cash flows driven by Mun (2002); Kyläheiko or asset price competition, demand and et al. (2002) management Not necessarily traded and Marketable and traded Brach (2003); Copeland proprietary in nature, with comparables information & Antikarov (2005) no market comparables Managerial decisions and No possibility to control and Copeland &Antikarov flexibility increase option manipulate option value (2001) value Actively acquired by Copeland & Antikarov Side bets management (2001) Mun (2002); Copeland Management assumptions & Antikarov (2005); Management assumption and actions drive the value Kodukula & Papudesu have no effect on valuation of the real option (2006); Kyläheiko et al. (2002) Competition and market Competition and market Trigeorgis (1996); value drive value of the value do not affect valuation Trigeorgis (1988) strategic option Usually small (proportional) Large scale decisions Mun (2002) values Numerical accuracy more Framing the option case Amram & Kulatilaka important more important (1999 ); Often rainbow and com- Trigeorgis (1996); Often single options pound options (parallel and Copeland & Antikarov sequential) with interactions (2005); Brosch (2008) Closed-form solutions Solved usually using closed- and binomial lattices with form PDE’s and simulation / Mun (2002); Copeland simulation of the underlying variance reduction tech- & Antikarov (2005) variables (not on the option niques analysis) Have existed for more than Practical use for Mun (2002) 30 years approximately two decade Dependent on both risk-free interest rate and Dixit & Pindyck Depends only on risk-free risk-adjusted premium or (1994); Kulatilaka interest rate equilibrium rate in dynamic (1995); Teisberg (1995) programming context Different and sometimes Ordinary payoff functions Zhou (2010) complex payoff functions 172 Lecture Notes in Management Science Vol. 4: ICAOR 2012, Proceedings Financial option Real option References Volatility increase after Volatility increases always Huchzermeier & Loch committed investments may beneficial (2001); Brosch (2008) have negative effect Expected value may be Option value known at known, but it may still have Brach (2003) exercise fluctuations in the future Majd & Pindyck Timing of option payoff (1987); Perlitz, Peske & Timing of option payoff delayed, not precisely Schrank (1999); known (immediate) known, and may spread Kodukula & Papudesu over a period of time (2006) Exercise time or time period Exercise time, especially Brach (2003); Copeland (for American option) known optimal one, not necessarily & Tufano (2004); Tri- in the beginning known antis (2005) May not have price for Trigeorgis (1996); Option has certain price to acquiring the option or the Kodukula & Papudesu acquire price is unknown (2006) Can be leveraged Cannot often be leveraged (Brach 2003) (Brach 2003); Pindyck Strike price may also be Strike price often known (1993); Kodukula & stochastic Papudesu (2006) Triantis (2005); Shared and proprietary Proprietary possibilities Trigeorgis (1996); nature Trigeorgis (1988) Managerial skills and Managerial skills and incentives do not prevent incentives may prevent Triantis (2005) value maximization value maximization May have information Usually no information Brach (2003); Copeland asymmetries with arbitrage asymmetries & Antikarov (2005) possibilities May have fuzziness or am- Precise parameterization Brach (2003) biguity in parameter values Owned, created and exer- Triantis (2005); cised by the cooperative Trigeorgis (1996); Owned by one party activity of more than one Smit & Trigeorgis company (2004) Copeland & Antikarov May not have negative Underlying asset may have (2005); Camara values negative values (2002); Haahtela (2006) Discrete information flow Lint & Pennings Continuous information flow with occasional managerial (2000); Willner (1995) reactions T Haahtela 173 Financial option Real option References Copeland & Antikarov Mostly European by nature Mostly American by nature (2005) Computational efficiency Computational efficiency Amram & Kulatilaka important less important (1999) Can be diversified Cannot be diversified Brandao et al. (2005) Valuation parameters are Valuation parameters mostly often secondary, derived primary and observable and estimated from the Haahtela (2011b) variables primary parameters of the cash flow simulation Sensitivity analysis based on More complex sensitivity Haahtela (2010b, the ‘Greeks’ analysis 2011b) All options are known in the Some options may be Brach (2003) beginning acquired during the project Not necessarily ability to Copeland & Antikarov Can be hedged hedge (2001) Another common problem is that many practitioners view the existing real option valuation models as too complicated to use and even more so to explain (Triantis, 2005). These real options models are like “extreme sports” that looks impressive but are hardly something that could be applied in a real business setting. Another problem, once again more academic, is that the real