Real options v2 Flashcards
(28 cards)
if we take static NPV as decision rule, what might be an error?
we neglect the case of investing later. We only consider ivnestment at one point in time, and this assumes a sort of “now or never” approach.
how to relate “investment + yearly costs” to options
we consider it as the strike price.
If by choosing to invest, we need to pay this, it becomes the strike. The strike price unlocks the cash flows that are positive.
The longer we defer, usually, the more valuable the option becomes.
relate the “cost” of waiting to options
we lose early revenue. This is the foregone dividends.
elaborate on the put protection in the calls used in real options
there is no put protection if there is no uncertainty.
if there is uncertainty, what can we say about waiting to invest?
It can give us more insight into the later outcomes
what is crucial to understand when using the binomial method with true probabilities?
the discount rate differ between peridos
do we ever find out when to invest using the binomial model for real options?
Yes, but we need to consider the american variant. we compare intrinsic value against continuation value at each node.
name the four types of real options
1) the decision about whether and when to invest in projects
2) The ability to shut down, restart, and permantly abandon projects
3) the ability to invest in projects that may give rise to future options
4) the ability to be flexible in later choices of inputs, outputs etc
how can we view the ability to shut down a project? money losing proejct
having the project + put option
If we have the ability shut it down, and thereby not losing more money, this is a put option because the put is an insruance policy for some specific limit. I suppose if we can save 10million by shutting down, the strike price is 10 million?
in electricity producing plant that peak load by operating only on days that provide profit, what can we say about the strike price?
The stirke price is the cost of all inputs combined to make electricity that day. The strike is therefore the cost we must pay to access the benefits. we only want to pay this strike if shit is profitable. Otherwise, we will not pay it.
define spark spread
spark spread is the difference between the price of electricity and the cost of producing the electricity.
Spark spread refers specifically to the usage of gas to generate.
how do we arrive at the fact that ability to shut down operation is equal to “investment + put”?
This is a weird card.
we use put call parity.
If we have the option to produce, and we have the potential asset value and the costs, we have all we need.
It is important to understand that the “investment”, as presnet value of stock price minus the strike price, is the same as the NPV static of the case.
how can we interpret the “value of plant”? there are 2 main ways
1) As a call option, or a strip of call options, deciding on whether to produce or not
2) Static NPV + Put option (in the case of bad conditions)
or a strip of them
what is staging?
Refers to building a binomial tree that allows a firm to make decisions in stages. At each stage, we can continue by paying further investment, or we can walk away.
Staging is done by making a regular forward tree. We compute the option value at each node. Then, at each layer in the tree, we can setup the tree so that each layer correspond to an investment barrier, meaning that we need to invest MORE at this point if we want the project to continue.
So, we compute option value at each node, and compare the cost of ivnesting more vs continuation value. If the continuation value is greater, we continue.
on the staging with binomial tree, exactly how is the method done?
we start by building the forward tree. As always. Use up and down factors.
The forward tree represent the market value of the assets. Purely revenue. It starts by considering some initial value. we assume this is estimated on some way.
Using this initial value, we build the forward tree.
Then we find payoff at expiration. This is done by subtracting the investment row at final level of prices from the market value at this level.
Then we use the regular risk neutral framework one step back. Now we subtract the next investment level directly from this continuation value to get the updated continuation value. If this is negative, we set it to 0. This indicates that we should not continue, meaning we should not invest this next level.
The nice thing is that this method ensures that continuation value always reflect whether we should go on or not.
The final price also bakes in the investment cost. If positive, we expect value from the project.
consider the single barrel oil extraction case. how do we solve it? w
Perpetual call option. This gives us when to invest.
Since single barrel, we enter the value of this barral, as provided at the time 0.
recall what the tradeoff is. We know that the barrel has a lease rate, and we are not getting this lease rate until we exercise.
By deferring, we earn interest on the extraction cost, which is the strike price.
Due to the behavior of the lease rate, forward prices will increase.
The idea is that we want to keep earning interest until the point in time where the payment from lease rate is better than interest. if we continue to defer, we will make our case worse. EXERCISE, receive the asset and bank on the lease rate instead of the interest.
why does the perpetual call formula know the rate of appreciation of the land?
we feed it as an input. THe input is dividend. We must understand that by waiting to invest, we give up dividend. When we invest, we receive the value.
Binomial model and the blakc scholes model accounts for continuously compounded dividends already.
what do we mean by “developed”?
machineneruy of equipment etc is acquired. no investment is needed to produce, except for perhaps variable costs.
Developed is not the same as “producing”
Developed means that we have installed the machinery, for instance the oil well. However, the extraction cost equivalent is not a part of this. We may or may not be paying this. We also may or may not be paying rolling costs that are required simply by maintaining the rig.
elaborate on shutdown
Shutdown refers to the case where we decide to pay some fee to shut down a well or plant etc, in order to stop costs assocaited with it. For instance, if the oil well is no longer profitbable, and we have running costs, we can shut down the well and stop these costs.
what happens if we perma shut down?
3 things:
1) We no longer sell . we give up revenue stream with present value S/∂ (in the case of constant growth)
2) we no logner pay extraction costs. This is valued at “c/r”.
3) we must pay the fee of shut down, k.
suppose we are operating a well. what is the value of it?
S/∂ - c/r
what is the value shutting down the well at some price S*?
The value of shutting down the well at that price is given as:
-S*/∂ + c/r - k_s
what can we consider a perma shutdown as, in option world?
the value of shutting down permanently is a put option, where the strike price is the (c/r - k_s) and asset price is -S*/∂
elaborate on permanently shutting down in regards to valuing it
We need to consider the total asset value as the “stock price” and we use the “costs of shuttign down” as the strike price. NOTE that the cost of shutting down has the obvious cost of the fee itself, but we subtract the value we GAIN from no longer paying running costs.
Reflect on why this above is WRONG.
Since it is a put, we are not paying the strike price, we receive it. Therefore, we must flip the signs. We get: strike price = value we get from no longer payng running costs - fee
