Options Concepts Richard de Neufville Professor of Systems Engineering and of Civil and Environmental Engineering MIT

Objectives of this presentation To stress the role of flexibility in systems design and management It provides the means to adjust to the consequences of inevitable risks To define Options, as the means to create flexibility Build upon their use in financial context Focus is on application to the design and then effective management of the evolution of the system over time To set stage for “Options Analysis”, the valuation of options The take-away: “options thinking” is crucial

Outline of Options Presentations Basic Concepts Flexibility is a key to effective development of systems Options are means to develop flexibility in systems “Options Thinking” is central to effective system design Valuation of Options Formal methods: Black-Scholes and Binomial Alternatives in Practice: Hybrid and Simulation Real Options -- those used in system design and management Merck, Kodak and other examples Issues in application of options thinking and analysis to engineering systems design

Traditional Practice Typically focuses on design to specifications Example: communications satellite system The System was designed to meet some specified level of performance (or “specs”) These specs decided outside the engineering practice (for example, by market and or financial analyses) Note that design is a complex optimization effort Cost Capacity Best design to specification

Actual System Performance is Uncertain Why is this? Because technological, market and other conditions uncertain Example: communications satellite system: Profitability depends on market size for system Profit Loss Market demand Design spec

Design involves a distribution of uncertainty Outcomes vary in probability Consequences of outcomes x probabililty => pdf (probability distribution function) Example: communications satellite system: Profit Loss Probability distribution

Probability distribution Design Opportunity To change the distribution of probability distribution to increase, maximize value Key means of doing this: flexibility that permits adaptation of design to circumstances Profit Loss Probability distribution Shift

Consequences of Flexibility (1) Accentuate the positive -- take advantage of opportunities (also known as “call options”) New pdf Original pdf Profit Loss

Consequences of Flexibility (2) Minimize the negative -- avoid big losses (as with insurance) (also known as “put” options) Profit Loss Original pdf New pdf

Stress on Flexibility Represents a real change in concept of design and management of engineering systems over time Why is this? Because: instead of designing to a spec, we design for a range of possible levels of performance Cost Performance Design to specification Design for expansion

Flexibility Adds Value Flexible systems Allow owner to adapt operating conditions Flexibility can reduce total operating costs Costs less to adapt to variability and change Accept a variety of raw materials Can efficiently process a wide range of batch sizes Allows advantageous use of inputs or production of outputs Example: flexible manufacturing systems Allow fast product change-overs

Flexibility Costs Money Complexity Time Equipment might require special configurations Extra Space for Expansion Complexity Production or management systems more complex Time Design and Planning Efforts take time

Central Design Issue What Flexibility should we incorporate in System? The question is in effect: What elements of flexibility are more valuable than their cost? How do we value flexibility? This is the central topic of options analysis and options valuation Developed in next several presentations

Example: Project R&D Uncertainty Start R&D project for $100,000 (0.1M) $1,100,000 (1.1 M) more to complete development Commercial feasibility determined by initial R&D results Plan to sell (license) technology to highest bidder Revenue estimate 50% chance to sell technology for $2000,000 (2M) 50% chance to sell for $100,000 (0.1M) Assume constant 10% discount rate applies Fund project?

Traditional NPV Valuation of R&D Year 1 2 Initial Cost (0.1) Develop- (1.1) ment License 0.5*2 Revenues 0.5*0.1 Present (0.1) (1) 0.868 Value

Tree for NPV Valuation of R&D Project should be rejected Com Good (1.1/1.1) 0.5 2/1.1^2 Com Bad (1.1/1.1) 0.1/1.1^2 Fund (0.1) Do Not Fund

Flexibility Perspective of R&D Develop only if $2000 license is expected Year 1 2 Initial Cost (0.1) Develop- 0.5*(1.1) ment License 0.5*2 Revenues 0.5*0 Present (0.1) (0.5) 0.826 Value

Tree for Flexibility View of R&D NPV = + 226 Should accept project Commit (1.1/1.1) 2/1.1^2 Abandon Good 0.5 Com (1.1/1.1) 0.1/1.1^2 Bad Fund (0.1) Do Not Fund

Lessons from R&D Example Ability to abandon project has significant value Limits downside Continue only if advantageous Standard NPV misses option value completely Fails to consider effect of intelligent management decisions Standard NPV distorts value when there is risk Assumes that: NPV with expected values = expected NPV “Flaw of the Averages” see article, also Exercise 2 However: Consequences of scenarios have asymmetries Example, production costs often not linear with volume Decision analysis has the advantage of recognizing value of flexibility

Decision Analysis May be Impractical Analysis may be too complicated Situation may change too often so that analysis too confused Example: Prices for Basic Resources fluctuate rapidly up and down Inadequate basis for Choosing discount rate When nature of risk constantly changing, … discount rate should also be changing … No single discount rate adequately covers situation See Presentation on Valuation for details

Example: Market Uncertainty of Inputs Case of Flexible Burner on Power Plant Turbines for electric power generation can be powered by Gas burners Oil burner Flexible, dual use burner (accepts either oil or gas) Fixed technologies (gas or oil) cost less to acquire than more complex flexible burner Under what conditions might flexible systems be valuable?

Specifics of Flexible Burner case Based on Kulatilaka and Marcus paper Price of gas: fixed at $1 per energy unit Price of oil: increases over time In Year 1 oil costs $0.75 per energy unit Price increases 5% per year Discount cash flows at 10% Installation occurs in Year 0 Operations start in Year 1 Revenues are independent of technology What is the NPV for each burner?

Oil burner cheaper to operate until Year 6 Base Case: Oil and Gas Prices assumed Known with Certainty Oil burner cheaper to operate until Year 6 Oil and Gas Prices $0.85 $0.95 $1.05 $1.15 $1.25 5 10 Year Price Oil Gas $0.75

Cash Flows Under Certainty

Results of Certainty Case Ranking of technologies Oil -- Flexible -- Gas Oil burner captures early cost advantages over gas Time value of money means early gains more significant than later losses Oil burner also better than flexible Both capture cost advantages early-on Flexible advantageously switches to gas in Year Extra cost of acquiring flexible > later gains Critical assumption: input prices are predictable

What if oil could follow one of three price paths? More Realistic Case: Uncertainty in Oil Prices What if oil could follow one of three price paths? Oil Prices $1.80 $1.40 High Medium Price $1.00 Low $0.60 $0.20 5 10 Year

Cash Flows with Uncertainty 1 2 3 4 5 6 7 8 9 O i l P n t R v u . C o s ( H g h ) p = M d i u m ) p = . 4 2 5 7 9 8 3 1 6 C o s t ( L w A v g P V N e a h F l - . 2 9 8 6 5 4 3 N P V F l e x i b a n t R v u 1 7 C o s ( H g h ) p = M d m 0.24 1.00 1 1 . C o s t ( L w ) p = 3 9 4 5 7 2 8 6 A v g P V N e a h F l - 1 . 0.63 .

Results of Uncertainty Case Rank of technologies Flexible -- Oil -- Gas Flexible technology enabled advantageous switching For high oil price: dual technology better than oil only For high gas price: dual better than gas alone Benefits accrue early on when uncertainty in prices is considered Operating cost savings outweigh additional acquisition costs

Lessons from Burner Example Real Situation can be VERY complicated Prices Change Rapidly They may go up and down in many pathways The switch between fuels can be exercised often Decision Analysis can be Impractical Simple Example Situation Already Difficult Analysis assumed fixed Discount Rate, But Discount rate should reflect volatility of prices As risk changes, so should discount rate Cannot change discount rate in decision analysis Another Method Required!!! => Options Analysis

“Options” = Formal Notion of Flexibility An Option is a formal way of defining flexibility Options valuation well developed for financial markets Field of real options applies theory to real projects Future decisions have features similar to financial options Financial options valuation can be extended to projects

What is an Option? A right, but not an obligation… Asymmetric returns; exercise only if advantageous Acquired at some cost to take some action… to switch fuels, drop project, buy or sell something, etc, etc, now, or in the future... May be indefinite, as for dual fuel burner Often for a limited time after which option expires for a pre-determined price. Cost of action separate from cost of option (down time for switching burners different from cost of dual fuel burner)

Example Financial Option Example: An Option to buy 100 shares of ATT at 20 through Jan. 2003 Option is a right. It allows, doesn’t force owner to ... … buy shares at a specified price … for a specific time (through January) “Strike” price is set in advance (at $15 in this case) Note: on November 13, 2003, quoted prices were: 1 share of ATT = $ 19.2 option on 1 share = $ 0.70

Asymmetry of Option Owner of Option Likely to exercise right to buy stock if its price > strike price or $X > $20 owner then makes profit = $(X - 20) these profits may be unlimited Owner not required to exercise option Loss limited to cost of buying option (example: $0.50/share) losses are limited Once you own this option, Value is not symmetric In this case: All gain, No pain Note: Other options might be all pain, no gain...

Example: “Real” Option “Real” Options concerns things, as distinct from “financial” options embodied in contracts Example: The spare tire on your car is an option that gives you the right ... to change the tire … the right in this case has unlimited time ... “cost” of exercising option = effort to change tire Note Similarity to Financial Option You will change tire only if you need to You do not have to do a thing about it

Financial Options Basics Focus on financial options because this is where methods of options valuation developed Financial Options (on stocks, commodities, FX…) Are tradable assets (see quotes on Financial Pages) Sold through exchanges similar to stock markets All options have similar basic features Option provides right to buy or sell stock Time period when option can be exercised is limited Strike price is pre-determined

Financial Options: Basic Types Two basic types of stock options Call: right to BUY stock for a set price Put: right to SELL stock for a set price The set price is known as the “strike” price Options can get much more complicated nested, one following another simultaneous, opposing each other very exotic -- not for now!

Financial Options: Time Limits Constraint on exercise defines 2 types European: can only exercise on expiration date American: can exercise at any time on or before expiration date American Options are much more realistic, especially for technological systems. Generally: Most decisions can be made at any time Remaining discussion focuses on American options, unless otherwise specified

Summary of Introduction to Options Flexibility has value, because of risk Good Systems Design will incorporate flexibility to respond to risk to manage evolution of system Issue is: How do we value flexibility? Options embody formal concept of flexibility Options have asymmetric returns “Options Analysis” defines value of flexibility “Options Thinking” key to efficient systems design