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Customer Review

on May 12, 2011
I totally agree with Cued's review.

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"
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