UNIVERSIDAD AUTÓNOMA DE MADRID
Degree in Economics and Finance
Derivatives Markets
December 5th, 2019
REAL OPTIONS IN CORPORATE INVESTMENTS
Eizaguirre, Óscar
Fernández, Eva
Santos, Sandra
Verjano, Andreana
, Financial options are derivative products that act as contracts. In these, a party
acquires the right, and not the obligation, to buy or sell in the future an asset, known as
an underlying financial asset, at a price previously set. There is a strong relationship
between the price of the underlying asset and the value of the option, being a positive
relationship in the case of call options (options to buy the asset in the future) and negative
in the case of put options (options to sell). There are different styles of options, among
which stand the American and European options. Americans have a key advantage, they
can be exercised at any time before the expiration date, while Europeans can only be
exercised on the expiration date.
So, how do they differ from the real options?
The only difference is, simply, the type of underlying asset, being in this case a real asset.
Also, mention that some of the basic characteristics of the options, such as the exercise
date and the price, will not always be accurately defined.
Real options can be used as a mechanism for the valuation of investment projects. Its use
will be more important when there is great uncertainty, high flexibility, complexity and
competitiveness. The traditional form of valuation, Cash Flows, are insufficient in these
cases (Frayer and Uludere (2001) and B. Fernandes, J. Cunha, P. Ferreira (2011)). The
Net Present Value method can be very difficult to estimate properly since the cost
structure of the company can be constantly changing, as well as the value of production,
for example, that is attached to the project. Trying to incorporate such factors within the
Net Present Value could provide result with less biased specifications.
Nonetheless, the valuation can be done using the techniques developed by Black, Scholes
and Merton, or the binomial model by Cox, Rox and Rubinstein (Vedevoto, and Prior,
2015).
There are different possibilities where options can be applied, such as expansion or
diversification projects, mergers or acquisitions, delays, or simply the abandonment of
investment projects.
After the acceptance of the financial options, they were soon applied to real assets,
highlighting the energy sector as stated by Suslick, Schiozer and Rodriguez (2009).
page 2
Degree in Economics and Finance
Derivatives Markets
December 5th, 2019
REAL OPTIONS IN CORPORATE INVESTMENTS
Eizaguirre, Óscar
Fernández, Eva
Santos, Sandra
Verjano, Andreana
, Financial options are derivative products that act as contracts. In these, a party
acquires the right, and not the obligation, to buy or sell in the future an asset, known as
an underlying financial asset, at a price previously set. There is a strong relationship
between the price of the underlying asset and the value of the option, being a positive
relationship in the case of call options (options to buy the asset in the future) and negative
in the case of put options (options to sell). There are different styles of options, among
which stand the American and European options. Americans have a key advantage, they
can be exercised at any time before the expiration date, while Europeans can only be
exercised on the expiration date.
So, how do they differ from the real options?
The only difference is, simply, the type of underlying asset, being in this case a real asset.
Also, mention that some of the basic characteristics of the options, such as the exercise
date and the price, will not always be accurately defined.
Real options can be used as a mechanism for the valuation of investment projects. Its use
will be more important when there is great uncertainty, high flexibility, complexity and
competitiveness. The traditional form of valuation, Cash Flows, are insufficient in these
cases (Frayer and Uludere (2001) and B. Fernandes, J. Cunha, P. Ferreira (2011)). The
Net Present Value method can be very difficult to estimate properly since the cost
structure of the company can be constantly changing, as well as the value of production,
for example, that is attached to the project. Trying to incorporate such factors within the
Net Present Value could provide result with less biased specifications.
Nonetheless, the valuation can be done using the techniques developed by Black, Scholes
and Merton, or the binomial model by Cox, Rox and Rubinstein (Vedevoto, and Prior,
2015).
There are different possibilities where options can be applied, such as expansion or
diversification projects, mergers or acquisitions, delays, or simply the abandonment of
investment projects.
After the acceptance of the financial options, they were soon applied to real assets,
highlighting the energy sector as stated by Suslick, Schiozer and Rodriguez (2009).
page 2
