The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 30

Real Options

Recall the example of the gas well, presented in Chapter 11, that was worth $500,000 given the average price of gas but was worth $1 million on average. The increased value was due to the option not to pump in the event that the gas price was below the production cost. An opportunity such as this is known as a real option, and it is analogous to a call option on the gas, with a strike price equal to the pumping cost.

Life is full of such options, and they all exploit uncertainty.

• Should I save money by making my plane reservations early or pay more for the option of flexible travel dates?

• Should I hire full-time employees, who cost less per hour, or have the option to easily reduce my workforce by using more costly temporary labor?

• Should I commit to my production quantities today to get the lowest per-unit cost, or should I maintain the option to produce what I really need after I have a better estimate of market demand?

Keeping Sailplanes Aloft

Before learning to fly sailplanes, I would watch them from the ground, circling so slowly in the sky, with no idea what kept them up.

The answer is real options. Here the uncertainty is what the air you are flying through will do. Still air represents complete certainty. On a still day, after you are pulled aloft by the tow plane, the best a pilot can do is descend at around 100 feet per minute, making for a short, boring flight.

In uncertain conditions, that is, turbulent air, the sailplane will again descend ...