Real options analysis

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A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm's factory is a real option. In contrast to financial options a real option is not tradeable - e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision. The terminology "real option" is relatively new, whereas business operators have been making capital investment decisions for centuries. However the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such the terminology "real option" is closely tied to these new methods. The term "real option" was coined by Professor Stewart Myers at the MIT Sloan School of Management.

This kind of option 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, downsizing, or abandoning other projects in the future. Other examples of real options may be opportunities for research and development, mergers and acquisitions, licensing and film options.

These are called "real options" because they pertain to physical or tangible assets, such as equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments. However, valuation methods, such as Net present value (NPV), do not include the benefits that real options might provide.

Generally, the most widely used methods are: Closed form solutions, partial differential equations and the binomial lattices. In business strategy, Real Options have been advanced by the construction of option space, where volatility is compared with value-to-cost, NPVq.

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