What are Real Options?

Real options are the flexibilities that are inherent in general business or other decision situations. In general, a real option is present in any decision situation involving a decision-chance-decision sequence; the possibility to (at the second decision) select from a range of different decision possibilities after the occurrence of the chance event may alter the choice of the decision earlier on in the sequence (and/or increase its value). The extra value created by this flexibility is sometimes described as a real options value.

Real options analysis concerns itself with analysing such flexibilities. On some occasions it may be desired to value such flexibilities explicitly. On others, the valuation is not explicitly required and the analysis concerns itself mostly with making the correct decisions and planning risk response or mitigation actions. The topic has links to financial market options, as well as to traditional net present value analysis.

A more detailed description of this topic, with example models using Excel, @RISK (software for risk analysis using Monte Carlo simulation) and PrecisionTree (decision trees in Microsoft Excel) can be found in Chapter 5 of my book Financial Modelling in Practice (John Wiley & Sons, 2008. ISBN-13: 978-0470997444).

Dr. Michael Rees
Director of Training and Consulting

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