Types of Flexibility = Options

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Presentation transcript:

Types of Flexibility = Options Richard de Neufville Professor of Engineering Systems and of Civil and Environmental Engineering MIT

Theme for this Presentation To place Concept of Flexibility in Design into broader perspective of “Options” Note that “options” in this context has a specific meaning  “alternative” Wide literature on “options” in economics – several presentations in rest of course will link it to flexibility in design In general: Flexibility in design = “real option”

Organization Formal definition of Options, along with basic types (“calls” and “puts”) Drivers of Option Value Asymmetry in Pay-offs Decision Analysis Illustrates process

“Options” Embody Idea of Flexibility “Option” : a formal way of defining flexibility “Option” has a specific technical definition Semantic Caution: The technical meaning of an “option” is… much more specific and limited than … ordinary meaning of “option” in conversation... where “option” = “alternative” Pay careful attention to following definition!

Technical definition: An Option is… A right, but not an obligation… “Exercise”, that is “use” only if advantageous Asymmetric returns -- “all gain, no pain” Usually acquired at some cost or effort to take some action… to change system, buy or sell something, etc, now, or in the future... May be indefinite Can be for a limited time only for a pre-determined (“strike”) price Cost of action separate from cost of option

Illustration of option definition Spare tire on car is an “option” because it provides right, but not an obligation… Operator can use it or not Acquired at some cost – price of tire, loss of space to take some action… to change the tire now, or in the future... In this case, whenever desired for a pre-determined (“strike”) price Time, effort of jacking up car, replacing tire, etc.

Types of Options Two basic types of options CALL: right to take advantage of an opportunity (e.g., ability to expand garage if demand is high) PUT: right to limit losses of a bad situation (which is what an insurance policy provides) Options in design can be complicated NESTED: one after another (e.g.: successful research => option on development; successful prototyping => option on production) SIMULTANEOUS: (e.g.: successful fuel cells research => options on hybrid cars and home use)

Real Options are Everywhere Examples: Lease equipment with option to buy Action is to buy at end of lease (or to walk away) Lease period defined up-front (typically 2-3 years) Purchase price defined in lease contract Flexible manufacturing processes Ability to select mode of operation (e.g. thermal power by burning either gas or oil) Switching between modes is action Continuous opportunity (can switch at any time) Switching often has a cost (e.g.: set-up time)

Generic Real Options Call-like Put-like Compound (nested) In detail… Capture benefits from increases in project value Exercise typically involves putting money into project Exercise when expectations of positive return increase Put-like Insure against losses from decreased project value Exercise may involve short-term costs or salvage value Exercise when expectations of losses Compound (nested) Projects might contain multiple options Exercise decisions based on overall profit maximization In detail…

Call-Like Real Options Waiting to Invest A project might be profitable today, but better tomorrow Leaving investment opportunity open ~ holding a call Deciding factors: uncertainty resolution; foregone profits Choice based on: Max [immediate investment, waiting, 0] Expand -- Accelerate effort or level of involvement Allows greater participation in upside Cost of expansion is like strike price Choice based on: Max [status quo, expanded project Restart Temporarily Closed Operations Similar to waiting to invest or expand (a special case) Choice based on: Max [remain closed, re-open]

Put-Like Real Options Abandon Ability to halt investment eliminates further losses might include shut-down costs and salvage values Choice based on: Max [continuing, abandoning] Contract -- Decelerate or narrow involvement Reduces participation level and exposure to losses Often incurs short-term scale down costs Choice based on: Max [status quo, contracted] Temporarily Shut Down Operations A special case of contraction Eliminates losses, but can incur shut-down costs Choice on: Max [status quo, temporarily shut-down]

“Real” Options “Real” because they refer to projects Contrast with financial options that are contracts Real Options are focus of interest for Design They provide flexibility for evolution of system Projects often contain option-like flexibilities Rights, not obligations (e.g.: to expand garage) Exercise only if advantageous These flexibilities are “real” options Let’s look at possibilities…

Compound or Nested Options Combinations of Options Many real options exist simultaneously E.g.: those to abandon, contract, or temporarily shut down Complex problem: value of multiple options are often interdependent and in general not additive Exercise may make others valueless (abandon ends project) Switching Between Modes of Operation (example: dual fuel burner case) Flexible systems contain an infinite series of options Allow continual switching between modes of operation If switching modes has a cost, it acts like a strike price For compound options, must value as system

Real Options “IN” and “ON” projects Those “real” because, in contrast to financial options, they concern projects, they are “ON” projects E.g.: the option to open a mine (Antamina case) These do not concern themselves with system design Most common in literature Those “real” because they concern the design elements of system, they are “IN” projects EX: options for staging of system of communication satellites These require detailed understanding of system Most interesting to system designers Financial options Options ON projects Options IN Real Options These need knowledge of system

Real Options “ON” projects These are financial options, but on technical things They treat technology as a “black box” Example: Antamina mine (detailed discussion later) option to open the mine after a two-year exploration period Uncertainty concerns: amount of ore and future price =>uncertainty in revenue and thus in value of mine Option is a Financial Call Option (on Mine as asset) Differs from normal Financial Option because Much longer period -- financial option usually < 2 years Special effort needed to model future value of asset, it can’t be projected simply from past data (as otherwise typical)

Real Options “IN” projects These create options by design of technical system They require understanding of technology Example: Communications Satellites Designers can create options for expansion of capacity by way they configure original satellites Technical skill needed to create and exercise option Differ from other “real” Options because Special effort needed to model feasible flexibility within system itself (e.g.: modeling of ‘trade space” for design of communication satellites)

Drivers of Option Value 2 Major Drivers Uncertainty is Principal Driver The greater the uncertainty, the higher the value Time is second driver The longer the option is available, the higher the value

Financial Options Focus first on financial options because This is where options and valuation developed Technical terms based on finance Financial Options Are tradable assets (see quotes finance.yahoo.com) Sold through exchanges similar to stock markets Are on all kinds of goods Stocks, that is, shares in companies Commodities (oil, meat, cotton, electricity...) Foreign exchange, etc., etc.

Types of Financial Options In addition to basic types of options Call: right to BUY asset for a set price Put: right to SELL asset for a set price Financial options can get very complicated In addition to Nested and Simultaneous Exotic possibilities (“Asian”, “Bermudan”, “caput”, “collar”….) see en.wikipedia.org/wiki/Exotic_option Not in this course !

Standard Option Terminology S = fluctuating market price of “underlying asset” S* = S at the moment owner of option takes advantage of right (when option is “exercised”) K = Strike price PAYOFF = owner’s net from a having the option, this is consequence we need to understand Let’s examine what payoff looks like…

Call Option Payoff Call Option gives person right to buy an asset for a predetermined “strike” price, K Only rational to exercise right when price of asset is greater than “strike” price: S > K If exercised, option owner pays price of K to get asset worth S* => Payoff = S* - K If unexercised, Payoff = 0 Formally, payoff = Max of either 0 or S* K = Max [0, S* K]

Payoff Diagram for Call Option ($) S Payoff of Option Price of Asset S - K K Asset Price ($)

Example of Current Call Option Example: A Call Option to buy 100 shares of Google (shares of Google constitute the “underlying asset”) at $350 per share (this is the “strike price”) through Jan. 16, 2009 On Nov 15, 2008, prices were (yahoo web site) 1 share of Google = $ 310.02 option to buy 1 share = $ 18.20 NOTE: option price> immediate value of exercise = $ - 39.98 Here’s what the payoff diagram looks like…

Payoff Diagram for Call Option Per share ($) S Payoff of Option Price of Google S - K Current Google Price K= $350 Price of Google share ($)

Put Option Payoff Put Option gives person right to sell an asset for a predetermined “strike” price, K Only rational to exercise right when price of asset is LOWER than “strike” price: S < K If exercised, option owner GETS agreed price of K for asset worth S* => Payoff = K - S* If unexercised, Payoff = 0 Net payoff for put = Max [0, K - S*]

Example Financial Option Example: A PUT Option to SELL 100 shares of Google at $300 per share (the “strike” price) Through Jan 16, 2009 On Nov 15, 2008, prices were (CBOE) 1 share of Google = $ 310.02 option to sell 1 share = $ 20.00 NOTE: option cost > value of immediate payoff = $ - 10.02

Payoff Diagram for Put Option ($) Asset Price S K K-S Payoff of Option Asset Price ($) K

Asymmetry is key to option value Asymmetry of Option For Call Option, if asset price > strike price… owner then makes profit – that could be unlimited Owner not required to exercise option, so… Loss limited to cost of buying option ( $18.20/share in Google example) Value of option not symmetric For owner of call option: All gain, No pain Note: This applies once you have option. Usually, you pay for option, so net value of option (after purchase) may have a loss Asymmetry is key to option value

What drives option value? How much should you pay for an option? Payoff diagrams show for a given strike price Call payoff increases with asset price increases Put payoff increases with asset price decreases Payoff does not reflect full value of option Why is that? Owner exercises only when advantageous In general, owner can wait for a higher price Value is Max[ immediate exercise, waiting]

Boundaries on Price Some logical boundaries on value of call option that can be exercised any time (American) Price > 0 Otherwise buy option immediately Price < S Option yields S*- K Option value < S Price > S - K Or buy and exercise immediately Payoff ($) Stock Price ($) K Upper Bound: Call Value Equals Asset Price Lower Bound: S

Why Payoff and Value Differ Consider an option whose current asset price equals strike price: (S = K) (it is “at the money”) Immediate exercise payoff is zero However, if you wait: Payoff might be higher Worst is zero payoff Value of waiting not reflected in immediate exercise, to be added Payoff ($) EV[S] S - K = value of option K Asset Price ($)

Value for All Stock Prices Value exceeds immediate exercise payoff Asymptotically nears immediate payoff for increased S If no upside: value (expectations) = 0 = value (option) Payoff($) S - K Value K Asset Price ($)

Option Value Increases with Volatility Two “at the money” options (S=K) on different assets Both have immediate payoff = 0 Asset A with greater volatility has higher P(larger net payoffs) => higher expected value Asymmetric value favors high variation (limited losses) Payoff ($) Asset A Payoff ($) Asset B pdf S-K S-K pdf K Asset Price ($) K Asset Price ($)

Life Time of Options Two basic types in finance: “European” options: oldest type, have fixed date for use (“exercise”) “American” options: you can use them any time over life – which generally has a definite end date (see Google examples) For DESIGN – Options are typically “American” with no end date

Impact of Time More time to expiration increases value of “American” options Waiting increases chance of value increase Longer- term contains shorter-term options + more time cannot be worse, can only be better Compare a 3 and 6 month American call Can exercise 6 month call at same time as 3 month Can wait longer with 6 month Which is more valuable? Must be longer one... Time impact not obvious for European options Could miss out on profitable opportunities

Generalized Value of American Call For a set strike price, value increases with Stock price increases Volatility Time Increased strike price Reduces likelihood of payoffs Reduces call option value Payoff ($) Value increases with volatility and time to expiration S - K Asset Price ($) K

Decision Analysis Example: Project R&D Risk 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 NPV misses option value completely Fails to consider effect of intelligent management NPV distorts value when there is risk Assumes NPV with expected values = expected NPV “Flaw of the Averages” see article by Savage But: Consequences of scenarios have asymmetries E.g., production costs often not linear with volume Decision analysis has the advantage of recognizing value of flexibility

Summary of Introduction to Options Options embody formal concept of flexibility Options are not “alternatives” 4 step Mantra “right, but not obligation, to act” “Calls” for opportunities, “puts” for risks Asymmetric returns => source of value Many “real” options available to designers “Real” Options “ON ” and “IN” systems