What is Real Option?
200 reads · Last updated: December 5, 2024
A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financial instrument.Real options differ thus from financial options contracts since they involve real (i.e. physical) "underlying" assets and are not exchangeable as securities.
Definition
Real options refer to the economically valuable rights that company managers have to make or abandon certain choices, typically involving business projects or investment opportunities. They are called 'real' because they usually involve tangible assets (such as machinery, land, buildings, and inventory) rather than financial instruments.
Origin
The concept of real options originated from the development of financial options theory. In the 1970s, as financial option pricing models matured, scholars began applying option theory to investment decisions involving tangible assets. Since then, real options have become an important tool in corporate strategic decision-making.
Categories and Features
Real options can be categorized into various types, including expansion options, abandonment options, and deferral options. Expansion options allow companies to scale up projects when market conditions are favorable; abandonment options enable companies to exit projects when they are no longer profitable; deferral options provide the flexibility to delay investment decisions. The main features of real options are their flexibility and ability to manage uncertainty.
Case Studies
A typical case is the application in oil field development by oil companies. Companies can choose to expand production when oil prices are high (expansion option) or suspend production when prices are low (abandonment option). Another example is real estate developers deciding whether to develop land immediately or delay development based on market demand changes (deferral option).
Common Issues
Common issues investors face when applying real options include accurately valuing the options and making optimal decisions under uncertainty. A common misconception is treating real options as traditional financial options, overlooking their uniqueness in managing tangible assets.
