TABLE OF CONTENTS The formulas used to value financial options are based on riskless arbitrage (the possibility of forming a portfolio that provides exactly the same return as the financial option) and are very accurate. However, we will see that very rarely does it make sense to use these formulas directly to value real options because real options are hardly ever replicable. However, we can modify the formulas to take non-replicability into account (see Section 22.7).
The problems we encounter when valuing real options are:
Difficulty in communicating the valuation due to its higher technical complexity than the present value
Difficulty in defining the necessary parameters for valuing real options
Difficulty in defining and quantifying the volatility of the sources of uncertainty
Difficulty in calibrating the option's exclusiveness
Difficulty in valuing the options adequately; in any case, their valuation is much less accurate than the valuation of financial options
Although real options are intuitively appealing, we will see that arriving at a value is complicated. Calculating the exact value of a real option is not critical; instead, understanding the value drivers of the option is more important.
It is not possible to value correctly a firm or a project that provides some type of future flexibility real options using the traditional techniques for discounting future flows (NPV or IRR). There are many types of real options: options to exploit mining or oil...
