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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

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

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

10. 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

11. 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

12. 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

13. 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

14. 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?

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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?

22. 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?

23. 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

24. Cash Flows Under Certainty

25. 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

26. 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

27. Cash Flows with Uncertainty1 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 .

28. 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

29. 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

30. “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

31. 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)

32. 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

33. 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...

34. 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

35. 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

36. 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!

37. 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

38. 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