THE PROMISE OF REAL OPTIONS

In recent years, both practitioners and academics have argued that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. This paper shows how option pricing models used in valuing financial assets can be used to value three kinds of real options that are often built into corporate projects: the option to delay, the option to expand, and the option to abandon. As a number of examples in this paper suggest, corporate investments that would be rejected using conventional DCF analysis can sometimes be justified by the value of the strategic options they provide. As the illustrations also show, however, the pricing of real options is considerably more difficult than the pricing of financial options and adjustments must often be made to capture the complexity of real investments.     

Determinants of corporate borrowing

Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.     

Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns

We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999) , but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book‐to‐market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data.     

Brealey,Myers, and Allen on Real Options

Real options are valuable sources of flexibility that are either inherent in, or can be built into, corporate assets. The value of such options are generally not captured by the standard discounted cash flow (DCF) approach, but can be estimated using a variant of financial option pricing techniques. This article provides an overview of the basics of real option valuation by examining four important kinds of real options:

• 1 The option to make follow‐on investments. Companies often cite “strategic” value when taking on negative‐NPV projects. A close look at the payoffs from such projects reveals call options on follow‐on projects in addition to the immediate cash flows from the projects. Today's investments can generate tomorrow's opportunities.
• 2 The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But often it's better to defer a positive‐NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flows—which are lost or postponed by waiting—are small.
• 3 The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use.
• 4 The option to vary the firm's output or its production methods. Companies often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another.

The authors also make the point that, in most applications, real‐option valuation methods are a complement to, not a substitute for, the DCF method. Indeed DCF, which is best suited to and usually sufficient for safe investments and “cash cow” assets, is typically the starting point for real‐option analyses. In such cases, DCF is used to generate the values of the “underlying assets”—that is, the projects when viewed without their options or sources of flexibility.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

Return predictability and shareholders’ real options

This study re-interprets the properties of the residual income model by highlighting the shareholders’ abandonment (liquidation or adaptation) option. We estimate the value of this real option as an explicit component of abnormal earnings in the residual income model and test the improvement in valuation after incorporating it into the model. Relative to the traditional specification of the residual income model, this real options model has a stronger predictive power for future abnormal stock returns. We also find that the superior return predictability of the real options model is pronounced in the set of firms with a high probability of exercising liquidation options (for example, those with low profitability, low growth opportunities, high underlying asset volatility, and low intangible assets), which is consistent with the importance of shareholders’ abandonment option in equity valuation. The results are robust to extensive sensitivity checks.     

STRATEGY AND SHAREHOLDER VALUE CREATION: THE REAL OPTIONS FRONTIER

The current interest in real options reflects the dramatic increase in the uncertainty of the business environment. Viewed narrowly, the real options approach is the extension of financial option pricing models to the valuation of options on real (that is, nonfinancial) assets. More broadly, the real options approach is a way of thinking that helps managers formulate their strategic options—the future opportunities that are created by today's investments—while considering their likely effect on shareholder value. But if the real options framework promises to link strategy more closely to shareholder value creation, there are some major challenges on the frontier of application. In the first part of this paper, the authors tackle the question, “What is really new about real options, and how does the approach differ from other wellestablished ways to make strategic decisions under uncertainty?” This article provides a specific definition of real options that relies on the ability to track marketpriced risk. Using examples from oil exploration and pharmaceutical drug development, the authors also show how specific features of the industry and the application itself determine the usefulness of the real options approach. The second part of the paper addresses the question: Given the many differences between real and financial options, how should a real options application be framed? The authors examine the use of real options in the valuation of Internet companies to demonstrate the required judgment and tradeoffs in the framing of real options applications. The case of Webvan, an online grocer, is used to illustrate the inter‐action between strategy, execution, and valuation.     

Using real options theory to explain patterns in the valuation of research and development expenditures

Real options theory posits that the value of the firm is a combination of the value generated by the assets in place and the value of the option to invest in the future. It is based on the idea that many decisions are difficult to reverse, and valuing the outcome of these decisions is more complicated than estimating the present value of future cash flows. R&D activities often generate real options due to the nature of these activities, and examining the valuation of R&D expenditures through the lens of real options theory can help explain differing results documented in both the R&D and value relevance of earnings and book value literatures. Numerous studies have documented that the stock market positively values R&D expenditures; however, recent work has raised questions about whether this positive relation occurs across firms reporting both profits and losses. Consistent with real options theory, I find that the negative coefficient on the R&D expenditures of profitable firms documented by prior studies only exists for low growth firms. In addition, for all R&D firms experiencing high sales growth, the market places a lower value on assets in place and a higher value on R&D expenditures.     

Revisiting the Tourinho real options model: outstanding issues 30 years later

This article presents and extends the first known model in real options, proposed in Tourinho (1979), and provides thoughts on addressing issues that are still outstanding 30 years later. It discusses the need to ensure the existence of market equilibrium when applying real options valuation to price assets, once all agents behave as suggested by the solution to the pricing equation. It argues that this can be achieved by using a stochastic process for the price that is sufficiently general to respond to supply and demand imbalances in the market for the resource. Once the individual decision rules are derived, the parameters of the process must be determined to ensure market equilibrium exists. For reserves of natural resources, this can be done by using a mean-reverting process for the price of the commodity and ensuring that the long-term price to which it reverts equals the trigger price for development of the marginal reserve.     

Valuing Assets Using Real Options: An Application to Deregulated Electricity Markets

This paper provides a detailed case of the application of real options valuation techniques to value a contract for the use of a power generation facility. The authors' aim is not primarily to offer a valuation "recipe" for a specific type of asset, but to show how the real options framework can be actually made to work in a variety of situations.
The case illustrates how minor adaptations that take into account the ways in which actual settings differ from the assumptions of standard formulas like Black-Scholes can be used to increase the precision and realism of results. By introducing relatively simple changes to a standard options valuation model, the authors obtain results that are reasonably close to those reported for actual transactions involving similar types of assets. Despite the industry-specific context of the analysis, the applicability of the techniques discussed in the paper should extend beyond the energy industry to other contexts characterized by similar types of uncertainty and production process, particularly those associated with minerals and other commodities.     

Dynamic complex hedging in additive markets

In general, geometric additive models are incomplete and the perfect replication of derivatives, in the usual sense, is not possible. In this paper we complete the market by introducing the so-called power-jump assets. Using a static hedging formula, in order to relate call options and power-jump assets, we show that this market can also be completed by considering portfolios with a continuum of call options with different strikes and the same maturity.     

Growth Opportunities and Investment Decisions: A New Perspective on the Cost of Capital

This paper shows that it is not always correct to make an upward adjustment to the stock beta in calculating the hurdle rate for capital budgeting even when the project under consideration is riskier than existing assets. The paper also shows that the correct hurdle rate is smaller than the market capitalization rate calculated from the firm's stock beta when the project under consideration has the same risk as existing assets. In addition, it is shown that the market capitalization rate will be an underestimate (overestimate) of the correct hurdle rate when the risk of future assets is greater (smaller) than both the risk of assets in place and that of future capital expenditures. These new results are direct consequences of the insight that the firm's investment opportunities are in fact real call options written on underlying assets.     

Corporate Investment and Asset Price Dynamics: Implications for SEO Event Studies and Long-Run Performance

We present a rational theory of SEOs that explains a pre‐issuance price run‐up, a negative announcement effect, and long‐run post‐issuance underperformance. When SEOs finance investment in a real options framework, expected returns decrease endogenously because growth options are converted into assets in place. Regardless of their risk, the new assets are less risky than the options they replace. Although both size and book‐to‐market effects are present, standard matching procedures fail to fully capture the dynamics of risk and expected return. We calibrate the model and show that it closely matches the primary features of SEO return dynamics.     

REAL OPTIONS: STATE OF THE PRACTICE

In the mid‐1980s, financial economists began building option‐based models to value corporate investments in real assets, laying the foundation for an extensive academic literature in this area. The 1990s saw several books, numerous conferences, and many articles aimed at corporate practitioners, who began to experiment with these techniques. Now, as we approach the end of 2001, the real options approach to valuing real investments has established a solid, albeit limited, foothold in the corporate world. Based on their recent interviews with 39 individuals from 34 companies in seven different industries, the authors of this article attempt to answer the question, “How is real options being practiced, and what impact is it having in the corporate setting?” The article identifies three main corporate uses of real options—as a strategic way of thinking, an analytical valuation tool, and an organization‐wide process for evaluating, monitoring, and managing capital investments. For example, in some companies, real options is used as an input into an M&A process in which rigorous numerical analysis plays only a small role. In such cases, real options contributes as a qualitative way of thinking, with little formality either in terms of analytical rigor or organizational procedure. In other firms, real options is used in a commodity trading environment where options are clearly specified in contracts and simply need to be valued. In this case, real options functions as an analytical tool, though generally only in specialized areas of the firm and not on an organization‐wide basis. In still other companies, real options is used in a technology or R&D context where the firm's success is driven by identifying and managing potential sources of flexibility. In such cases, real options functions as an organization‐wide process with both a broad conceptual and analytical core. The companies that have shown the greatest interest in real options generally operate in industries where large investments with uncertain returns are commonplace, such as oil and gas, and life sciences. Major applications include the evaluation of exploration and production investments in oil and gas firms, generation plant investments in power firms, R&D portfolios in pharmaceutical and biotech firms, and technology investment portfolios in high‐tech firms. While the approaches to implementation are quite varied, there appears to be a common path to the successful adoption of real options. The key steps of the adoption process are: (1) conducting pilot projects; (2) getting buy‐in from senior‐level and rank‐and‐file managers; (3) codifying real options through expert working groups, specialist training, and customization; and (4) institutionalizing and integrating real options firm‐wide. After citing best practices for each of these four steps, the authors close by predicting that a “network” effect and acceptance by Wall Street will serve as catalysts for more widespread corporate use of real options.     

Subjective evaluation of delayed risky outcomes for buying and selling positions: the behavioral approach

This paper analyzes time discounting as a function of risk, using reservation prices. Based on experimental data, we compare bidder reservation prices for riskless assets with those for risky assets. The experiments rely on a second price auction with real monetary incentives and real delay in payoffs. We estimate the pure time discount rate for different maturities, considering riskless assets (bonds) and risky assets (delayed lotteries). An innovation in the experimental design allows disentangling pure time from pure risk discounting effects. If subjects bid for assets, we find implied discount rates for risky assets to be uniformly lower than those for riskless assets, across all maturities (the risk moderation effect). However, there is no risk moderation effect if subjects quote ask prices. We argue that delaying a payoff has a stronger effect on the price of bonds than on the price of risky assets since, in the case of bonds, the investor moves from a position of certainty to a position of risk, or uncertainty. Our findings on the risk moderation effect may be used to explain the attractiveness of compensation contracts with options, as commonly used in the financial industry.     

American options: the EPV pricing model

Summary We explicitly solve the pricing problem for perpetual American puts and calls, and provide an efficient semi-explicit pricing procedure for options with finite time horizon. Contrary to the standard approach, which uses the price process as a primitive, we model the price process as the expected present value of a stream, which is a monotone function of a Lévy process. Certain processes exhibiting mean-reverting, stochastic volatility and/or switching features can be modeled this way. This specification allows us to consider assets that pay no dividends at all when the level of the underlying stochastic factor is too low, assets that pay dividends at a fixed rate when the underlying stochastic process remains in some range, or capped dividends.The authors are grateful to the anonymous referees for valuable comments and suggestions.     

Making real options really work

As a way to value growth opportunities, real options have had a difficult time catching on with managers. Many CFOs believe the method ensures the overvaluation of risky projects. This concern is legitimate, but abandoning real options as a valuation model isn't the solution. Companies that rely solely on discounted cash flow (DCF) analysis underestimate the value of their projects and may fail to invest enough in uncertain but highly promising opportunities. CFOs need not--and should not--choose one approach over the other. Far from being a replacement for DCF analysis, real options are an essential complement, and a project's total value should encompass both. DCF captures a base estimate of value; real options take into account the potential for big gains. This is not to say that there aren't problems with real options. As currently applied, they focus almost exclusively on the risks associated with revenues, ignoring the risks associated with a project's costs. It's also true that option valuations almost always ignore assets that an initial investment in a subsequently abandoned project will often leave the company. In this article, the authors present a simple formula for combining DCF and option valuations that addresses these two problems. Using an integrated approach, managers will, in the long run, select better projects than their more timid competitors while keeping risk under control. Thus, they will outperform their rivals in both the product and the capital markets.     

Is there a real estate factor premium?

In this paper, we study the variation of expected returns on five different asset portfolios in a multi-factor model. We found the presence of a real estate factor, in addition to both a stock factor and a bond factor in asset pricing. This suggests that mutual fund managers should seriously consider including real estate assets in their portfolios, since one cannot capture the real estate factor premium without having some kind of real estate exposure. Another result is that the market segmentation found in previous studies disappears in a more general model of asset pricing in which we allow for multi-factors other than the market factor to affect asset returns. This implies that real estate assets can be treated just like other assets as far as mean-variance efficient asset allocations are concerned. We also have some preliminary evidence that equity REITs and the Russell-NCREIF index are driven by the same underlying real estate factor.     

Exchange options under clustered jump dynamics

Exchange options are one of the most popular exotic options, and have important implications for many common financial arrangements and for implied beta as a measure of systematic risk. In this study, we extend the existing literature on exchange options to allow for clustered jump contagion dynamics in each single asset, as well as across assets, using the Hawkes jump-diffusion model. We derive the analytical pricing formulae, the Greeks, and the optimal hedging strategy via Fourier transforms. Using an illustrative numerical analysis, we present the relationship between the exchange option price and clustered jump intensities and jump sizes in the underlying assets. We discuss the managerial insights on financial arrangements with exchange option characteristics. Furthermore, we discuss the implications of incorporating clustered jumps into the estimation of implied beta with exchange options, in which the applications can be insightful and useful in finance practice.     

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firm's investment opportunity set. The results show that, on a relative scale, the market‐to‐book assets ratio has the highest information content with respect to investment opportunities. Although both the market‐to‐book equity and the earnings–price ratios are related to investment opportunities, they do not contain information that is not already contained in the market‐to‐book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market‐to‐book assets ratio.