A Real Option’s Perspective of Capital Budgeting 239Chapter 12
12. A Real Option’s Perspective of Capital Budgeting
of Capital Budgeting
OBJECTIVES
Introduction to financial options.
Bring out the analogy between financial and real options.
Introduction to types of real options.
Valuation of real options.A derivative is a financial instrument or contract between two parties that derives its value from some under-
lying asset or reference price, interest rate, or index. Options, futures, swaps, and forwards are derivative instru-
ments. Underlying assets include interest rates, exchange rates, commodities, stocks, stock indices, and bonds.
Derivatives are traded both on recognized exchanges and in the over-the-counter market.
Companies, financial institutions, individuals and institutional investors use derivatives for a variety of
reasons. Companies may use derivatives to manage interest rate and foreign exchange rate risk. Investors in
stocks may trade in derivatives to manage exposure to equity prices. People may trade in derivative instruments
either to hedge risk or to speculate. Derivatives enable individuals to allocate economic risks efficiently by
transferring risks from risk-averse individuals to those who are willing to bear.
Options are derivative instruments that can be used as a means to hedge or speculate. Options are written
on both financial and real assets. Option contracts on foreign currency, stocks, stock indices, interest rates, com-
modities and Treasury bonds.
An option is a contract between the buyer of the option and the seller (writer). The contract gives the buyer
of the option the right but not the obligation to buy the underlying asset at a specified price (strike price) at
a specified time in the future (expiration date or maturity date). The buyer of the option pays an option
premium to the seller for obtaining the right. The seller of the option is however obligated to honor the
contract. The option to buy an asset is called a call option and the option to sell an asset is called a put option.
Here is an example of call and put option written on ACC stock: