Real Options in Practice

Rarely, a book of immense breadth comes along so little understood by its publisher that it is launched as a technical manual for industry insiders when, in fact, it is a seminal work in many fields. Marion A. Brach, a physician with a background in medical research and a deep understanding of mathematics, migrated to finance. She took an interest in real options, which is the field of valuation of choices in the real as opposed to the financial world and in due course produced her book.

Dr. Brach’s interest is, at its core, whether X corporation should buy Y corporation or invest a known amount of money in a project. This sort of thing has usually been handled by discounted cash flow analysis. If Y can add a known amount of money to X’s business, then the purchase price of Y must not exceed the discounted cash flow it brings in.

What’s wrong with discounted cash flow is that it ignores risk, as Dr. Brach points out.That’s a huge gap and one which real options can fix.

The corrective value of real options pricing is obvious. The downside of real options is that it takes a good deal of math, usually partial differential equations, to do it. Financial calculators are alr eady available at modest prices to handle the Black-Scholes model of options pricing, but real options that involve corporate planning require a deeper sense of what the math is about. As Dr. Brach points out, a model for a deterministic solution, such as how much to pay for a right to buy a what contract that will expire at a known price, zero, at a given time, is different from the situation of a process that has a stochastic or even randomized outcome.

Dr. Brach moves her story and analysis from biblical accounts of grain trading and a developing and parallel options market and Joseph’s choice of whether to save grain to guard against seven years of famine. Thales, the Greek philosopher, bought call options on olive presses well before a harvest and was able to raise press rents at the small cost of the options he bought.

The story of the development of real options moves from Greek olives to Dutch tulips and then to theories of thermodynamics. Dr. Brach mentions the roots of real options analysis in Russian and French investigations of probability theory, the use of Brownian motion as a foundation for stochastic theories of where prices will be in successive periods, and assumptions about market clearing and interest rates.

There are investigations of the value of learning and the reduction of noise, the applications of game theory to outcome analysis, and a consideration of where real options is going and where its usefulness may end. The strength of the book is its sweeping view of the field of the valuation of events, the clarity of Dr. Brach’s writing, a fine19 page bibliography, and her ability to tell her story without delving into mathematical physics – the source of much of the analytic power of real options analysis.

For the investor, this value of this book about the analysis of non-financial options is what it says about the limitations of conventional investigations of future financial events. For thoughtful folks not concerned about figuring out the price of a financial options, Dr. Brach provides a glimpse of analysis as it will likely be in a decade or two. This reviewer cannot recommend this book too highly. For a reader with a little calculus and some statistics, it’s not hard reading. For anyone, it is an adventure with a very bright mind– Toronto Globe & Mail

Real options are useful tools that can guide a firm’s strategic planning and can create or enhance a firm’s value. That’s why real options are quickly becoming the valuation and decision-making method of choice for companies in competitive industries. The fact is that no matter what field you’re in-financial, pharmaceutical, energy, or technology-if you’re a corporate decision-maker, real options can help you make the right decisions at the most critical times.

In Real Options in Practice, Marion Brach presents the world of real options from the vantage point of a corporate practitioner applying real option valuation techniques on a regular basis. Through in-depth insights, detailed formulas, charts, and case studies, you’ll receive an executive education on real options that cannot be found anywhere else.

To bring you up to speed on this topic, Real Options in Practice opens with a unique and comprehensive history of real options, from their earliest beginnings to the present. From here, you’ll learn how to transform real option theory into a real-world framework that will produce tangible results. Real Options in Practice touches on only the most important issues. It discusses the relevance of Black-Scholes and Binomial Option Pricing models in relationship to real options, explains the basic managerial options you must know-deferral, abandonment, expansion, switching, and compounding-and explores the value of uncertainty within a real options environment. You’ll also gain a firm understanding of new trends in real option theory, including the intersection of game theory with real options, and real options in preemption and technology positioning.

Rounding out this comprehensive guide to real options are further discussions of real option analysis as a corporate strategy. You’ll see how real option analysis can be implemented in contractual relationships; the shortcomings of the real option method that must be taken into consideration to ensure the best use of the paradigm; as well as the organizational challenges, in implementing real option concepts.

By exploring the fascinating world of real options, where and why they are applied to corporate decision-making, and, most importantly, the challenges of implementing a real option framework in practice, Real Options in Practice offers you the most accurate and informative guide to using real options in a corporate setting.