The Mathematics of Financial Models: Solving Real-World Problems with Quantitative Methods

CHAPTER 9 Real Options

In previous chapters, I restricted my discussion to the explicit valuation of financial options. In practice, the concept of optionality is something one faces daily in both a personal and business capacity. As such, it is important and interesting to see if one can use ideas discussed in the earlier chapters to value such options or decisions. Before discussing how to do this, I will first illustrate some practical examples of real options.

Real options¹ are options couched as decisions that one can optimize on. Examples of this include decisions to abandon a project, expand on an investment, scale down an operation, defer an investment, or cancel a project.² Although this has been the traditional definition of a real option, for the purpose of this book I will use the term real options in a broader context so as to also include the ability to quantify the value of a choice. More precisely, in addition to the above, I will use the term real options to also include the quantification of choices associated with operations management, optimal allocation, decision making under uncertainty, amongst others. As such, additional examples of real options include:

• Deciding when to turn on and off power generating units (e.g., hydroelectric stations, fossil units, coal plants, nuclear stations) so to optimize profits.
• Operating a gas storage facility in a manner to optimize storage facilities and manage the supply and demand for storage space as gas prices fluctuate ...