Real Options
Overview
A real option is the right to take some action (or not take the action) with respect to some asset. As an example,
a contract to have the right to rent some office space at some point in the future (but not necessarily forced to rent the space)
is a valuable right and would termed a real option.
Real options are often embedded in various projects, and each has some financial value. The ability to
value real options helps financial planners to understand business and project value.
Real options share alot of the terminology and theory of
financial derivatives (options).
Modeling Frameworks
The standard to valuaing a real option is simliar to the approach to solve a
simple game
in game theory. That is, the process works by backward induction.
- The values a the end (maturity) of the process are known
- Move back one step to the last decision point. The value of the option at the decision point
is the maximum of the value along the decisions branchs. That is, it is assumed that the agent
will choose the branch yielding the highest value. If teh outcomes along a branch is uncertain,
the value of the branch is determined using a measure of
stochastic present value.
- Continue moving back to each decision point, computing the value at each decision point
- The value of option is the computed value at the first decision point.
