In finance an option is a contract between the option buyer (holder) and the option seller (writer). The buyer buys this contract from the seller (writer) for a fee (premium).
The option (contract) gives the buyer the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price (strike price), at the expiration of the contract (European Option), or during a period of time (American Option).
The seller (writer) of the option contract has the obligation to allow the buyer to exercise the option at any time during the contract period.
Real Life Options
In fact we are using options in real life without even noticing. Effectively when you book a room in advance, sometimes you are required to pay a non-refundable fee (premium), in case you don't show up.
Once you pay the non refundable fee, you have the right to rent the room at the predetermined price. If you don't show up, you lose the premium.
A. Let's present a simple example with a call option (the right to buy an asset):
Hotel customer pays a non-refundable fee of $10, to book a room for $100, in 1 month from now.
Hotel owner gets the $10 and agrees to supply the room at the price of $100 in 1 month.
A1. Now if room prices increase to $150 in 1 month from now (due to an unexpected event). The customer exercises the contract and rents the room for $100, instead of $150. Effectively the customer gains: $50 less the $10 for the fee, so a profit of $40.
The hotel owner loses $50, but gains from the $10 fee, so a loss of $40.
A2. If room prices decrease to $50. The hotel customer will not exercise the option, and will just rent the room at $50. Therefore he will lose the $10 fee.
The hotel owner on the other hand will gain $10 from the fee.
Effectively in the example above, the hotel customer bought (long) a call option with a strike price of $100, exercisable 1 month from now, with a premium of $10.
The hotel owner sold (short) a call option with a strike price of $100, exercisable 1 month from now, with a premium of $10.
B. Let's see now the example of a put option (the right to sell an asset):
A real estate developer wants to sell his property in 1 year from now, for $1.000.000. To entice the buyer, the developer gives him $100.000 upfront.
The buyer agrees to buy the property in 1 year from now if the developer decides to do so, and keeps the $100.000 (no matter what happens).
B1. In 1 year from now, if prices increase and the property can be sold now for $2.000.000, the developer will not exercise the option, and will sell the property on the open market.
So the developer effectively loses the $100.000.
While the other party keeps the $100.000.
B2. If prices decrease to $600.000, the developer will exercise the contract and effectively will sell the property for $1.000.000. So he will gain $400.000 and lose the $100.000, so a total profit of $300.000.
The buyer is bounded by the contract to buy the property at $1.000.000. So he loses $400.000 and gains $100.000 from the fee, so a total loss of $300.000.
In the example above, the developer bought (long) a put option with a strike price of $1.000.000, exercisable 1 year from now, with a premium of $100.000.
The buyer sold (short) a put option with a strike price of $1.000.000, exercisable 1 year from now, with a premium of $100.000.
The excel below allows you to calculate the value of an option (call or put) which effectively is the premium paid from the buyer to the seller.
Real Options in Capital Budgeting
Real options in capital budgeting consist of the right but not the obligation to proceed with a business decision, which usually consists of:
- Delaying the decision until conditions (prices, costs, financing) are better:
Start-up firms or projects which derive most of their value from the rights to a product or a service (pharmaceutical , technological or commercial innovation based on patent).
A patent may be exercised if the net cash flow expected from creating the product/service is higher than the cost of creating the product.
The undeveloped reserves are treated as options on the natural resources possessed by a company.
As the price of gold, oil, or other natural resources fluctuates, the project could have a positive net present value and or a negative one. This leads to a potential call option where the option is exercised if the gold price meets a certain value.
- Abandoning the project if the project falls apart:
A company might want to invest in a new project, but worry about the investment not paying off.
In this case, the company might consider introducing a clause, that might allow the company to abandon the project if it does not go as expected, without having to continue the project to the end of its operational life.
The above can be viewed as an option to abandon the project.
- Considering the potential of the expansion:
Companies sometimes might enter a project with a negative net present value, so as to unlock additional investments (which have a greater potential in terms of Net Present Value), or enter new markets (in terms of countries and / or products).
However when implementing this initial project (project without expansion) which has a negative cash flow, the company unlocks the option of further expanding (value of expansion option).
This case applies to global / network companies (i.e. Amazon) which operated at losses for years, before becoming very profitable (effectively taking into account their global expansion option).
- Estimating the potential value of a company:
A troubled firm, a firm that is either with negative cash flows, with a high debt gearing, and / or a significant probability of going bankrupt, can be treated as a call option.
Many people do not think that the company will survive. If you wanted to value this company you could treat it as an option.
Despite being in a distressed situation, the equity still has value due to the probability of the company increasing its value before the debt payment is due (turnaround of the company).
Effectively the debt of the company has a maturity, during which, the value of the company might grow again and become viable (given the volatility of the company’s total value).
Check the excel file below to value real options: