Introduction
Economic investment decisions, such as purchasing new equipment, increasing the work force or developing new products, as well as project economic valuation, are affected by economic uncertainty, technical uncertainty and by the managerial flexibilities embedded in the project. Economic uncertainty is caused by factors external to the project and is generally represented by stochastic oscillations in product prices and by costs. Technical uncertainty is caused by internal factors, such as uncertainty regarding the production size and the project’s performance as a result of the technologies employed. The managerial flexibilities that are built into projects give managers the freedom to make decisions such as to invest, to expand, temporarily shut down or abandon a given project. Such flexibilities are called real options. If any one of these possibilities is ignored in the economic analysis, the project may perhaps be under-assessed and this may lead to irreversible decision-making errors. Therefore, managerial flexibility has a value which is not taken into account by conventional techniques such as the net present value (NPV) and the internal return rate (IRR) techniques. In addition to uncertainty, real options also consider managerial flexibility and their objective is to maximize the investment opportunity value.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Preview
Unable to display preview. Download preview PDF.
References
Dixit, A.K., Pindyck, R.S.: Investment under Uncertainty. Princeton University Press, Princeton (1994)
Copeland, T., Antikarov, V.: Real Options – A Practitioner’s Guide. Texere LLC Publishing (2001)
Hull, J.C.: Options, Futures, & Other Derivatives, 4th edn., p. 698. Prentice Hall, Englewood Cliffs (1999)
Black, F., Scholes, M.: The Pricing of Options and Corporate Liabilities. Journal of Political Economy (81), 637–659 (1973)
Trigeorgis, L.: Real Options – Managerial Flexibility and Strategy in Resource Allocation, p. 427. MIT Press, Cambridge (1996)
Trigeorgis, L., Mason, S.P.: Valuing Managerial Flexibility. Midland Corporate Finance Journal 5(1), 14–21 (1987)
Kensinger, J.W.: Project Abandonment as a Put Option: Dealing with the Capital Investment Decision and Operating Risk using Option Pricing Theory. In: The Annual Meeting of the Financial Management Association (October 1980)
Kensinger, J.W.: The Capital Investment Project as a Set of Exchange Options, Finance Department Working Paper, University of Texas at Austin (first draft: August, revised: November) (1986)
Brealey, R.A., Myers, S.C.: Principles of Corporate Finance, 8th edn. McGraw-Hill, New York (2005)
Ross, S.A., Westerfield, R.W., Jaffe, J.: Corporate Finance, Editorial Irwin, International Student Edition, 4th edn., USA (1996)
Grant, D., Vora, G., Weeks, D.E.: Path-Dependent Options: Extending the Monte Carlo Simulation Approach. Management Science 43(11), 1589–1602 (1997)
Ibáñez, A., Zapatero, F.: Monte Carlo Valuation of American Option Through Computation of the Optimal Exercise Frontier, Working Paper, Instituto Tecnológico de México & University of South California, p. 30 (August 1999)
Longstaff, F.A., Schwartz, E.S.: Valuing American options by Simulation: A Simple Least-Squares Approach. The review of Financial Studies, The Society for Financial Studies 14(1), 113–147 (2001)
Elton, E.J., Gruber, M.J.: Modern Portfolio Theory and Investment Analysis, 5th edn. John Wiley & Sons, Inc., Chichester (1995)
Levy, H., Sarnat, M.: Portfolio and Investment Selection: Theory and Practice. Prentice-Hall International, Inc., Englewood Cliffs (1984)
Brennan, M., Schwartz, E.: Finite Difference Methods and Jump Process Arising in the Pricing of Contingent Claims: A Synthesis. Journal of Financial and Quantitative Analysis 13, 462–474 (1978)
Cox, J., Ross, S., Rubinstein, M.: Option Pricing - A Simplified Approach. Journal of Financial Economics 7, 229–263 (1979)
Bellman, R.S.: Dynamic Programming. Princeton University Press, Princeton (1957)
Hammersley, J.M., Handscomb, D.C.: Monte Carlo Methods. Methuen & Co., London (1964)
Boyle, P.: Options: A Monte Carlo Approach. Journal of Financial Economics 4, 323–338 (1977)
McKay, M.D., Conover, W.J., Beckman, R.J.: A Comparison of Three Methods for Selecting Values of Input Variables in Analysis of Output from a Computer Code. Techno metrics 21, 239–245 (1979)
Owen, A.B.: Orthogonal Arrays for Computer Experiments, Integration and Visualization. Statistica Sinica 2, 439–452 (1992)
Tang, B.: Orthogonal Array-based Latin Hypercube. Journal of the American Statistical Association 88, 1392–1397 (1993)
Boyle, P., Broadie, M., Glasserman, P.: Monte Carlo Methods for Security Pricing. Journal of Economic Dynamics and Control 21, 1267–1321 (1997)
Broadie, M., Glasserman, P.: Pricing American-Style Securities using Simulation. Journal of Economic Dynamics and Control 21, 1323–1352 (1997)
Author information
Authors and Affiliations
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2009 Springer-Verlag Berlin Heidelberg
About this chapter
Cite this chapter
Lazo, J.G.L., Pacheco, M.A.C., Vellasco, M.M.B.R. (2009). Real Options Theory. In: Pacheco, M.A.C., Vellasco, M.M.B.R. (eds) Intelligent Systems in Oil Field Development under Uncertainty. Studies in Computational Intelligence, vol 183. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-93000-6_2
Download citation
DOI: https://doi.org/10.1007/978-3-540-93000-6_2
Publisher Name: Springer, Berlin, Heidelberg
Print ISBN: 978-3-540-92999-4
Online ISBN: 978-3-540-93000-6
eBook Packages: EngineeringEngineering (R0)