The term “Real Option” refers to an additional decision possibility that is created in any real-life situation if one extends the scope of permitted decision alternatives. For example, to the decision as to whether to book a vacation now or not go on vacation at all, one may allow the decision as to whether to go on vacation to be taken later. The real options “value” is the additional value that may be created by allowing these additional decision possibilities.
Real options are most frequently described within situations in which there is uncertainty. In such situations, value may be created by the ability to make the final decision only when some of the uncertainty has been resolved. However, there is no requirement for uncertainty to be present, only that there is an additional decision possibility that has been created or is available for some reason.
It is worth recalling that best practices in decision-making involve ensuring that a full range of decision options are generated and considered. Therefore, the creation of real options is at least implicit in any such best practice decision process. The choice of which decision possibility to follow does not therefore always necessitate an explicit calculation of the real options value, only the assessment of which decision alternative is the best one.
The explicit calculation of real options value can be challenging for several reasons, including:
- There is often a need to model decision sequences (one decision taken after another, perhaps with some uncertain process that occurs between the two e.g. the final decision about the vacation is taken only after the price of the vacation and the likelihood of needing to cancel it for some reason are known).
- Optimality of decision-making. Almost all valuation assessments in finance are based on the assumption that decisions are made optimally, and that value is maximised. This is often hard to model in practice, for example the Excel platform is often not adapted to model decision sequences, and tree-based or other approaches are required. Also, valuation in finance is based on mean (average) discounted outcomes, whereas real-life decision making needs to take risk tolerances into account.
- Discount rate. Hen trying to assess the beta to use the CAPM for example, a genuine comparable may be hard to find. Some people use a risk-free discount rate, relying on the word “option” (rather than “decision”) to assume that one should use a risk-free rate. But real options are not hedge able and tradeable financial options, so there doesn’t seem to be any clear justification for using a risk-free rate.