Real Option Valuation of Product Innovation

Chapter 3, Introduction of Real Option Valuation

The Definition of an option

Option is a definition in capital budgeting. An option provides the buyer (holder) the right (but not the obligation) to exercise by buying or selling an asset at a set price (called an exercise price or a strike price) on (European style option) or before (American style option) a future date (the expiration date). An option is often classified as call option and put option.

Exercise price is the amount of money invested to exercise the option if you are ‘buying’ the asset with a call option, or the amount of money received if you are ‘selling” it with a put option.

Underlying asset for a financial option is a security such as a share of common stock or a bond. For example, in a stock option to buy 100 shares of BlackBerry at EUR 140 at the end of year 2007, the BlackBerry share is the underlying asset. In a futures contract to buy EUR 10 million 10 year German Government Bonds, the underlying assets are the German Government bonds.

Underlying risk is that you may lose the money you invested – your capital. It is a measure of the variance of possible outcomes. A risk is related to the expected losses which can be caused by a risky event and to the probability of this event. A financial risk is often presented as the unexpected variability or volatility of returns, and thus includes both potential worse than expected as well as better than expected returns.

A Call option gives the buyer the right to buy the underlying asset at an exercise price, at any time prior to the expiration date. At expiration date, the option is not exercised and expires worthless if the value of the underlying asset is less than the exercise price. If the value of the asset is greater than the exercise price, the option is exercised – the buyer of the option buys the stock at the exercise price. Figure 3.1 illustrates the cash payoff on a call option at expiration. The net payoff is negative (and equal to the price paid for the call) if the price of the underlying asset is less than the exercise price. If the price of the underlying asset exceeds the exercise price, the difference between the price of the underlying asset and the exercise price comprises the gross profit on the investment. The net profit on the investment is the difference between the gross profit and the price paid for the call initially.

A put option gives the buyer the right to sell the underlying asset at exercise price, at any time prior to the expiration date of the option. At expiration date, if the price of the underlying asset is greater than the exercise price, the option will not be exercised and will expire worthless. If the price of the underlying asset is less than the exercise price, the buyer will exercise the option and sell the stock at the exercise price. As shown in figure 3.2, a put option has a negative net payoff if the price of the underlying asset exceeds the exercise price. If the value of the underlying asset is less than the exercise price, a gross payoff equals to the difference between the exercise price and the price of the underlying asset. The net payoff is the gross payoff minus the price paid for put option initially.

Difference between Real Options and Financial Options

Both of real options and financial options are the right but not the obligation, to take an action.

A real option is the right, but not the obligation, to undertake some business decision, at a predetermined cost called exercise price, for a predetermined period of time – the life of the option. These are called ‘real options’ because they pertain to physical or tangible assets, such as equipment, rather than financial instruments. It is a choice that an investor has when investing in the real economy (i.e. in the production innovation of goods or services, rather than in financial contracts).

In contrast to financial options, a real option is not tradable - e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision. It is not a derivative instrument, but an actual tangible option in the sense of ‘choice” that a business may gain by undertaking certain endeavors. For example, by investing in a project or property, a company may have the real option of expanding, deferring, or abandoning other projects in the future. Other examples of real options may be opportunities for research and development, mergers and acquisitions, etc.

The underlying asset for a real option is a tangible asset, for example, a business unit or a project while the underlying asset for a financial option is a security such as a share of common stock or a bond.

The value of underlying asset: Financial options are written on traded securities. It makes much easier to estimate the parameters of financial options. The security price is usually observable, and we can estimate the variance of its rate of return either from historical data or by calculating the forward-looking implied variance from other options on the same security. With real options, the underlying risky asset is usually not a traded asset. It is difficult to estimate the value of underlying asset from market.Copeland and Antikarov proposed the marketed asset disclaimer assumption (MAD). Combining the ration of a ‘twin security’ and the Mason and Merton assumption, the MAD states that the real asset value is perfectly correlated with itself and is the best unbiased estimate of the market value of the real asset were it traded. Therefore, the real asset value should be used as the underlying security.

The possibility of enhancing the value of the underlying asset is another important difference between financial and real options. Most financial options are side bets. The company on whose shares they are contingent does not issue the financial options. The independent agents who write them and buy those that are written issue them. Consequently, the agent that issues a call option has no influence over the actions of the company and no control over the company’s share price. Real options are different. Management controls the underlying assets on which they are invested and implements their decisions with time series. For example, a company plans to start a new product innovation project. Management may have the right to abandon it and may choose to do so if its present value is low. However, if the company comes up with a new idea that raises the present value of the underlying project (without flexibility), the value of the right to abandon may fall, and the company may decide not to abandon. Usually, the act of enhancing the value of the underlying real asset also enhances the value of the valuation.

The possibility of changing the risk by management: With both financial and real options, risk - the uncertainty of the underlying - is assumed to be exogenous. This is a reasonable assumption for financial options. The uncertainty about the rate of return on a share of stock is, in fact, beyond the control or influence of individuals who trade options on the stock. The actions of a company that owns a real option may affect the actions of competitors, and consequently the nature of uncertainty that the company faces.