[MUSIC] This module is about the use of real options in project selection. First, we will look at what options are and then talk about real options, which are options on real assets as opposed to financial assets. This quote from Judy Lewent, CFO of Merck is appropriate. All business decisions are real options in that they confer the right, but not the obligation to take some initiative in the future. After defining options and real options, we'll look at the early history of the use of real options and taxonomy of real options. The last topic in this session will be on flexibility and value of real options. There are basically two types of options, calls and puts. There are other more complex options, which are essentially combinations and are variations of these basic types. We'll only look at basic calls and ports and then talk about real options. A call option is the right, but not the obligation to buy a specified quantity of asset by paying the specified exercise price or strike price on or before the expiration date. So let us look at each item and the definition of a call option. For instance, a specified quantity of some underlying asset may refer to say 100 shares of [INAUDIBLE] industries limited. For commodity options, you not only have to specify the quantity but also the grade and the quality of the commodity. In addition, you need to mention where the underlying assets used to be delivered for if the option is exercised. In order to exercise the option the holder of the option has to pay the specified exercise price called the stride price. The biolophical option has to pay what is refered to as the premium in order to acquire the right, but not the obligation. The seller of the call option collects the premium and has the obligation to sell the specified quantity of the underlying asset, if and when the call is exercised. There are two types of call options, namely the American and the European option. An American option can be exercised on or before the specified date called the expiration date. While the European option can be exercised only on the day of expiration. An important point to notice that the holder of the option has no obligation to exercise the option. For instance, a European call option and say Microsoft would not be exercised if the expiration date, the market price of the shared Microsoft is less than the strike price. In this sense, we can think about buying an option is like buying insurance to protect oneself against an adverse event. Which in this case is the market price, the underlying asset increasing above the strike price. Put option gives, the holder of the option, the right but not the obligation to sell a specified quantity of some underlying asset for the specified exercise or strike price on or before the expiration date. Other than the fact that the food option gives the right, but not the obligation to settle. Other features that are put options are the same as indicate as the call option. In other words, the quantity of the underlying asset, the quality of the underlying asset and very distribute daily word if it's just a commodity. The strike price and the expiration date have to be specified. As in the case of a call option, there are two types of put options. Namely an American put option, which may be exercised on or before the expiration date. Or a European put option, which can be exercised only on the expiration date. The options that are traded on exchange are referred to as exchange traded options. In effect, the exchange acts as an intermediary between those wanting to buy the options and those wanting to sell the options. Since those selling options have an obligation to sell the underlying asset if the call option is exercises to buy the underlying asset of the put option is exercise. The exchange or the broker will require those persons to maintain appropriate balances in their margin account. Real options are options on real assets such as plants, machinery, buildings, oil fields, IT infrastructure, etc, as oppose to financial assets such as shares. Let us look at the history of real options. One of the earliest recorded use of real options is in the writing of the Aristotle. There is the story of Thales who live in the island of Milos in the Mediterranean. He had the ability to read tea leaves and reasonably accurately forecast olive harvest. That was his hobby, and one year he read the tea leaves. And his focus was going to be a bountiful olive harvest. He was smart, and not denouncing the prediction. But instead, bought a call option from the owners of the olive prices. That is the right to rent, but not the obligation to rent the olive prices for the usual rate during the harvest season. The rate at which you can rent the olive prices during the harvest season is the strike price. You acquire the right, but not obligation to rent by paying a premium which was essentially most of his savings. The owners of the olive prices were glad to collect the premium from Thales and confer the right, but not the obligation to rent. As Thales had predicted to himself but not to the public, the harvest exceeded all expectations. And olive grow was a rush to the process to excite that precious oil. Thales then of course, exercises option two by paying the user rental amount, and gain full control of all the olive prices. Which has the much larger amount than the user rental rate to the olive growers and record not only the premium he had paid, but also he earns substantial profit. The value of an option depends upon the value of the underlying asset, which in this case is the rental value of the olive prices. Which would be higher than the usual rental value when there's bountiful harvest. Besides the value of the underlying asset, the value of an option depends on the strike price, the time to expiration, risk free rate, and the standard deviation of the continuously compounded annualized return. Next, we look at taxonomy to understand what people mean by different options. Option to invest now or at a later date is refered to as a deferral option. Typically, this will be an American call option are more accurately at the mood call option which maybe exercised at specified times in the future, up to some specified time. Option to append or contract operations is like selling some more of the assets for a price. This option would be a put option. Option to expand or extend the life of a project is a call option. Option to switch use exist assets therefore for one purpose maybe used for some other purpose. Recall that we have talked about call and put options, but we can also have what is called a compound option. That is when you exercise the first option, you get another option. When you exercise the second option, you get a third option, and so on. Of course, this process much come to an end in the sense that, when you exercised the last option, you acquired the underlying asset. For instance, you may have phased investments. The first phase is the design phase, and you have to decide whether you want to go into the design phase or not. But once you go into the design phase, at the end of this phase when the design is over. You have an option to go into the engineering phase, but you do not necessarily have to go into the engineering phase. For instance, if the design throws up many problems and issues, you may decide that it's not worthwhile going into the engineering phase and abandon the project. But if you exercise the option to go into the engineering phase, you'll get at the end of the engineering phase. An option going to the final phase which is the construction phase. The engineering phase in this case is not desirable to go into the construction phase because of various identified reasons. They may abandon the project, you decide to exercise the option then construction would begin. Option to shut down and subsequently restart the manufacturing plant is a compound option. For instance, the demand is very low because some of the reasons you may want to shut down the factory for a year and restart the factory next year if the situation improves. This is a compound option in that the first option is to shut down the factory which like a put option. If this option is exercised you get the second option which is like a call option to restart the factory, one year later. One source of uncertainty that we talked about is the value than the lying asset. We can also have multiple sources of uncertainty such as uncertainty enterprise of product and uncertainty in the quantity of the product that can be produced. For instances, we may have the uncertainty of the price of an aggregate of the product and also uncertainty in the quantity of the product that maybe produced. Options where there are multiple sources on uncertainty are referred to as rainbow options. The value of the deferral option depends upon the likelihood of getting more information that were reduced to uncertainty, and the ability to react to the new information. For instance, suppose you're producing garments according to some fashion design. Sales for these garments are seasonal. And it is very difficult, if not impossible to predict accurately the total sales for the season which say is approximately one month. Now instead of producing large quantities of the garments before the season starts. You may diced to produce only a limited quantity before the season starts. Observe the sales said during the first week of the season and decide whether to produce additional quantity of the same garments. Essentially rate for one week to get more information about sales, if sales are high and produce to continue during the remaining season. You'll want to quickly produce additional quantities of the garment. Now the question is how soon you can respond to the new information that you have received about the sales? If you can respond quickly, the additional information that you got has some value. If on the other hand the production process is such that it takes a long time to produce these garments that is new information that you get, is not of much value. We can summarize what we have been talking about in a two by two table. The two columns of the table correspond to low or high likelihood of getting new information. The two rows of the table correspond to low or high ability to respond to the new information. The likelihood of getting new information and the ability to respond are both low then the option value that is the value of flexibility will be low, bottom left hand corner of the table. On the other hand, if the likelihood of getting new information and the ability to respond are both high. You have high value of flexibility as in the top right hand corner of the table. In the other two boxes, namely where the likelihood of receiving new information is high. But the ability to respond is low or the likelihood of receiving new information is low while the ability to respond is high, you will have only moderate value of flexibility. The value of flexibility becomes important when the value of the project without flexibility is close to break even. That is when the value of the project without flexibility is close to break even. You are not sure whether you will undertake the project or not. If the value of flexibility's high, then it will be better to wait and decide later. When some of the uncertainty has been resolved ss to whether if you undertake the project or not. Earlier there were limited applications of real options. Because models could only handle one source of uncertainty, that is market price. Now a days with the advancement of the technology models can take it their gun multiple sources are uncertainty. Some of each may not be market price. Furthermore the models can handle more complex options including compound options. It also have options calculators and hand held computers with software that quickly find the value of the options. This concludes this module. [MUSIC]
