- Series: Financial Management Association Survey and Synthesis
- Hardcover: 246 pages
- Publisher: Oxford University Press; 1 edition (December 15, 1998)
- Language: English
- ISBN-10: 9780875848457
- ISBN-13: 978-0875848457
- ASIN: 0875848451
- Product Dimensions: 9 x 1.1 x 5.9 inches
- Shipping Weight: 1.2 pounds (View shipping rates and policies)
- Average Customer Review: 20 customer reviews
- Amazon Best Sellers Rank: #1,683,717 in Books (See Top 100 in Books)
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Real Options: Managing Strategic Investment in an Uncertain World (Financial Management Association Survey and Synthesis) 1st Edition
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Huge payoffs in business usually entail embracing lots of risk. That's the message of Real Options, by Martha Amram and Nalin Kulatilaka. The authors argue that standard models of evaluating strategic investments fail to consider the element of risk fully. "Uncertainty creates opportunities. Managers should welcome, not fear uncertainty," write Amram, a California-based consultant, and Kulatilaka, a Boston University finance professor, in describing the "real options approach." The book provides plenty of theoretical case studies, formulas, and charts that demonstrate how to shape business strategies using a system based on option-pricing. The method can value everything from undeveloped land to untried products. "With it, market leaders will understand how value is created in an uncertain environment and will know how much risk they are bearing," the authors write.
Risk is also inherently dangerous--that's an unintended lesson of Real Options. The two Nobel Prize-winning economists whose work serves as the foundation for this book--Robert Merton and Myron Scholes--were the brains behind Long-Term Capital Asset Management, the notorious hedge fund that was rescued under a plan engineered by the Federal Reserve. With that caveat in mind, business planners and managers should pursue Real Options with their eyes wide open. --Dan Ring
"Real Options is an exciting, accessible introduction to one of the most useful innovations of modern finance. Filled with lively examples from various industries, the book reveals the strategic power of real options in business planning."--David G. Luenberger, Professor of Engineering-Economic Systems and Operations Research, Stanford University, and author of Investment Science
"This new book by Martha Amram and Nalin Kulatilaka provides a much-needed treatment of real options theory aimed at the practitioner. It is comprehensive, highly readable, and replete with useful examples. Every corporate finance practitioner should have a copy of Real Options on hand. --Robert S. Pindyck, Mitsubishi Bank, Professor of Applied Economics, MIT Sloan School of Management, and coauthor of Investment Under Uncertainty
"Uncertainty is the greatest risk a manager faces--and provides the greatest opportunity for creating value. This book offers a way of thinking that helps managers balance the risks with potential payoffs when making decisions in an uncertain world. The real options approach is a simple yet potent method that great leaders--military, political, and economic--use implicitly. Real Options is an excellent introduction to these concepts and their applications."--James Wall, Treasurer and Controller, AirTouch Communications
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Most of the other reviews are absolutely right: this book seriously lacks any quantitative explanation. No need to look for kind words; this is a serious oversight. And yes, this book does read like a long sales resentation.
While the authors adequatley describe broadly how economists and financial executives solve contingency claims problems (generally using binomial methods, simulation, or partial differential equations), they don't teach any of these methods in any useful way. At best, after reading this book, you will be able to recognize whether or not your organization has any "real options".
Beyond the quantitative short-comings of this book, however, there are some flawed fundamentals about their whole approach: this book treats real options as a new finance panacea for the 1990's, and suggests that the world of finance in 20 years will be a very different place because of these revolutionary ideas. Contingency claims problems are limited to a very specific set of economic phenomena with specific criteria. If the criteria are not present, contingency claims models fall apart. Consider the amount of abuse something as well-known as the black-scholes option pricing equation is subject to when it is applied to "real options valuation": the black-scholes equation is a function of two variables, primarily: time and stock price variance. When you take this equation and try to apply it to, say, the valuation of an option to market patented drug, how do you define variance and time? Time in an option contract is fixed in the contract. Variance is empirically observable from stock prices. Plus, how do we know that the value of drug patents resembles stock prices (log-normal process)? What if it is more like the behavior of a commodity (mean-reverting process)? And where are we going to get the data from anyway? In that case, the black-scholes equation needs to be abandoned and an alternative partial differential equation needs to be developed. But who is going to do that? At what cost? Obviously, at a certain point the benefits derived from exactly modelling your options is eclipsed by the cost and effort involved in doing so. The scariest part, however, happens when you realize that the greater the variance (risk) and the longer the timeframe chosen, the greater the final value of a project or investment. Now the project manager who wants to sell ice to the eskimos has the quntitative methods available to justify such a high risk project. (Just think, the project manager could sell this project to top management as a long-term investment anticipating the melting of the polar ice caps, when the price of ice in Greenland is expected to go through the roof).
This book tries to reach too far, suggesting that phenomena which never should be valued as contingency claims can be valued as such. Real options (or contingency claims) are best treated as a very specialized set of quantitative techniques used to model very specific phenomena which a company may or may not be subject to see "Investment under Uncertainty" by Dixit and Pindyck for an inventory of those phenomena). Push the envelope too far and the paper tears as it does here.
Real options theory has been a remarkable consensus in Academia. It is very hard to find articles / books online or offline that directly attack Real Options methodology. It seems a kind of profanity.
The principle of arbitrage capital market (like Delta Hedge Portfolio) is an important basis for giving an intuitive understanding why the Black-Scholes option price formula does not depend on the estimated price for the underlying asset (Notice that Markowitz Optimal Portfolio uses it)
But the arbitrage (and diversification too) hardly applies in the context of real companies, though it would be the desire of a well-diversified shareholder who is indifferent to the risk of internal company because it is diversifiable.
Furthermore, a high volatility asset with and enough time, turns projects OTM (Out of The Money) positive, i.e., many times, even if the investment is lesser than the NPV of forecasted project's cash flow, everything can be solved, if there are enough volatility and time.
This value can not be wrong if the asset is very dependent on the market, only that the risk of the option can not be exercised is high and it may be that the company has no reserves for this kind of setback.
In Academic work there are thousand of intricate Real Options modelling (for instance, JAIMUNGAL, Sebastian; LAWRYSHYN, Yuri. "Incorporating Managerial Information into Real Option Valuation", Toronto University, 2011 )
Most modern paper like that get rid of naive Random Walk and Black Scholes formula.
However, in most models, one try to find an asset or portfolio that correlates well with the desired target (contingent claim). but many times that correlation is just data snooping mixed with fake trend correlation. Besides, in many situations the real project is so stochastic and complex that it is difficult find this replicating portfolio.
Another common process for incomplete markets is the use of dynamic programming using a risk adjusted rate, with all the vices inherent at the CAPM model.
Volatility measures, Geometric Brownian Movement and other math artefacts, generally make part of this game. It doen't matter that the author believe or not in EMH (Efficient Market Hypothesis). Market prices is all about chaos, shaking and manipulation.
In the real world, out of the Capital Market, Free Cash Flow is a compound figure that mix many different variables, that surely internal information within the company helps to elucidate and that he is influenced by the macroeconomy (like commodity price or the whole demand), but depends strongly from actions and decisions that occur within the company or project.
I believe that exists a real academic obsession in compares any private company with capital market in some way.
After all, in the real world the private risk, project risk mixed closely with the market risk, even inside the same variable and no option type (simple or complex) encompasses all, not nearly.
This book itself is primitive and deals with Real Options like a God of Valuation (It does not show any realistic limitations of Real Options).
The book is little quantitative, very verbose and furiously attack alternative methods (Analysis Simulation and Decision Tree) in 3 or 4 lines on pages 39 and 40.
The best practical Real Options books are the Kodokula and Papudesu's book Project Valuation Using Real Options: A Practitioner's Guide. and Real Options Analysis: Tools and Techniques for Valuing Strategic Investment and Decisions, 2nd Edition (Wiley Finance).
The latter book presents a nice explanation about the intuition behind lattice trees and lattice equations.
Avoid also the Tom Copeland's book (Real Options, Revised Edition: A Practitioner's Guide), it's confusing and it have a lot of typos.
I have developed a new concept of Valuation, whose abstract can be read here
(greatsolutions dot com dot br barra publint dot htm)
The article is "Debunking Market-Driven Valuation"