Real Option
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.
Real Options
Definition
Real options refer to the economically valuable rights that company managers can choose to exercise or abandon, 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. Real options differ from financial options contracts because they involve physical (i.e., actual) 'underlying' assets and cannot be traded as securities.
Origin
The concept of real options originated in the 1970s, initially to address corporate investment decision-making under uncertainty. Over time, real options theory evolved and gained widespread application in the 1990s, particularly in industries such as energy, mining, and real estate.
Categories and Characteristics
Real options can be categorized into various types, including expansion options, abandonment options, deferral options, and flexibility options. Expansion options allow a company to scale up a project if successful; abandonment options permit a company to cease investment if the project is unsuccessful; deferral options enable a company to delay investment decisions while waiting for more information; flexibility options provide the ability to adjust the project under different market conditions.
Specific Cases
Case 1: An oil company discovers a new oil field and can choose to develop it immediately (exercise the expansion option) or wait for oil prices to rise before developing it (exercise the deferral option). This choice allows the company to optimize its investment decisions in an uncertain market environment.
Case 2: A real estate development company purchases a piece of land and can choose to build immediately (exercise the expansion option) or wait for more favorable market conditions (exercise the deferral option). If market conditions deteriorate, the company can also choose to sell the land (exercise the abandonment option) to minimize losses.
Common Questions
1. How do real options differ from financial options?
Real options involve tangible assets, while financial options involve financial instruments. Real options cannot be traded as securities.
2. What are the application scenarios for real options?
Real options are widely used in industries such as energy, mining, and real estate, helping companies make more flexible investment decisions under uncertain conditions.
