Book contents
- Frontmatter
- Dedication
- Contents
- List of Tables, Figures and Boxes
- Foreword
- Preface to the First Edition
- Preface to the Second Edition
- Acknowledgements
- Part–I Introduction
- Part–II Forwards and Futures
- Part–III Swaps
- Part–IV Options
- 10 Options – I: Introduction to Options
- 11 Options – II: Pricing of Options
- 12 Options – III: Equity Options Strategies
- 13 Advanced Options Strategies
- 14 Options – IV: Real and Other Options
- Part–V Other Derivatives and Derivative-like Instruments
- Part–VI Accounting, Taxation and Regulatory Framework
- Part–VII Portfolio Management and Management of Derivative Risks
- Bibliography
- Index
14 - Options – IV: Real and Other Options
from Part–IV - Options
Published online by Cambridge University Press: 02 August 2019
- Frontmatter
- Dedication
- Contents
- List of Tables, Figures and Boxes
- Foreword
- Preface to the First Edition
- Preface to the Second Edition
- Acknowledgements
- Part–I Introduction
- Part–II Forwards and Futures
- Part–III Swaps
- Part–IV Options
- 10 Options – I: Introduction to Options
- 11 Options – II: Pricing of Options
- 12 Options – III: Equity Options Strategies
- 13 Advanced Options Strategies
- 14 Options – IV: Real and Other Options
- Part–V Other Derivatives and Derivative-like Instruments
- Part–VI Accounting, Taxation and Regulatory Framework
- Part–VII Portfolio Management and Management of Derivative Risks
- Bibliography
- Index
Summary
This chapter concludes the treatment of options with a brief discussion of real options and employee stock options.
Real options
Independently of the derivatives markets, life is full of situations involving ‘options’ in the conventional English language meaning of the term. These situations often do have financial consequences, as shown in Example 14.1.
Example 14.1
A Professor in a university who has a tenured (i.e., permanent) post is contemplating a new offer from a private company that offers her a much higher salary. She is not expecting to return to the University. However, there is always some uncertainty and less security of tenure in the private sector. She can retain a lien on her university post for three years by applying for leave without pay (sabbatical) but this involves paying a pension contribution which will not bring any extra pension benefit. If she is successful in the private sector, the amount she pays will be a waste. However, if she is unsuccessful, she can get back her University post. In this situation, retaining her lien would be the equivalent of buying a call option on the job—the premium is the amount of pension contribution. This is an example of a real option.
More formally and quantitatively, the concept of real options is used in corporate finance and capital budgeting. Stewart Myers coined the term ‘real option’ in 1977.
Example 14.2
M Ltd. proposes to acquire a copper mine. The mine is already in production and has some reserves, which are profitable to exploit at any price above $3,000. Current prices are approximately $6,000 per ton. Traditional discounted cash flow techniques have been used to arrive at a valuation of the cash flow from the production expected each year. However, there are also some reserves that will be viable to extract only at prices higher than $9,000. The seller is insisting that the price must include a premium to reflect this potential future value. There is no certainty that the price of $9,000 would ever be reached; however if it is reached then a substantial additional cash flow will arise. Intuitively, it is obvious that this potential has some value but X Ltd. is not clear how to value this.
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- Information
- Derivatives , pp. 225 - 232Publisher: Cambridge University PressPrint publication year: 2017