Real options is the modern approach to capital budgeting. This approach considers the value of the opened options for the decision makers.
The origin of the term "real options" can be attributed to the Prof. Stewart Myers ("Determinants of Capital Borrowing", Journal of Financial Economics, vol.5, 1977), who first identified the fact that many corporate real assets can be viewed as call options.
The real options approach is dynamic in the sense that includes the effect of uncertainty along the time, and what/how/when the relevant real options shall be exercised.
The real options problem can be viewed as a problem of optimization under uncertainty of a real asset (project, firm, land, etc.) given the available options.
Although Black-Scholes-Merton and financial options came first in the 70's,
and the mathematical methods are the same, real options approach is not a mere
adaptation of financial options approach.
There are several differences
between real options and financial options. Four examples:
1) for real
options sometimes are important to consider the time to build the
underlying asset;
2) real options in general have longer time to expiration
than financial options, sometimes even perpetual real options, as
the case of land.
3) private uncertainties sometimes are very
important in real options models.
4) the decision rule
(earlier exercise threshold or critical value) is much more important in real
options applications than in financial options. By the other side, the "greeks"
play no important role in real options models (although is very important for
financial options).
Main types of real options (for a detailed real options classification, see the Trigeorgis' textbook (1996):
Example of real options: sequential options in exploration and production of petroleum.
There are a controversy if the use of dynamic programming for
optimization under uncertainty can be considered as a part of "real options" or
not.
Some people even say that it is "investment under uncertainty", not
"real options".
Although the "contingent claims" approach is preferable if
the market is complete, for incomplete markets the use of "dynamic programming"
with an exogenous discount rate is not only a good but a practical tool to
consider the available managerial flexibility (the "real options") into a
dynamic framework with uncertainty (see FAQ 5).
So, as Dixit & Pindyck
(1994), I consider "real options" and the modern "investment under uncertainty"
as synonyms.
In order to characterize a modeling as a "real options approach" the
important is to recognize the relevant options available to the decisors and a
model to capture a fair value for these real options in a uncertainty
environmental. For me it is a maximization of value subject to the uncertainties
and given the (real) options available.
The use of market values must be used
always is possible. But the lack of some market values doesn't mean that real
options approach is not possible.
As Amram & Kulatilaka say, real
options "is a way of thinking".
