Real Option Analysis Using Black SCholes Model

Abstract

Real options valuation is a financial technique fi>r evaluating investments under conditions o f uncertainty, particularly uncertainty associated with market variables such as future product demand or the fiiture value o f an asset. Option pricing is a well-developed area o f financial engineering, dealing with the valuation o f puts, calls etc., hut it is understood as a real option, when it is applicable to real assets like building, plant & machinery' etc. Real option analysis has become imperative to capture the value o f a company due to future growth from new product variations, expansion o f capacity fo r existing products. Black Scholes model o f option pricing is able to use variables like volatility, exercise price to predict value o f a given situation. In this paper, we explore the existence o f options in business decisions. It will have a small introduction to options, determinants o f option pricing and the basics o f option pricing. This paper would u.se Black Scholes model to find real option values in a given situation o f a product/service and interpret to understand its importance & implications on the future o f the given situation. Keywords: Real As.sets, Black Scholes Model, Option Pricing, Exercise Price INTRODUCTION Thales, a famous Sophist Philosopher circa 6(X) B.C., gazed into the star-studded sky one evening and predicted an outstanding, olive harvest, the next season. For a small up-front fee, he bought the right from the owners of the olive presses to rent them for the usual rate during the harvest season. If the harvest turned out to be meager, there would be less need for the presses and Thales would not rent them, losing the up-front fee. But if the harvest was bountiful, he would rent the presses at the regular agreed upon Prof. Prakash M. Chawla is an Associate Professor - MBA, E-mail: prakashchawla(X)@gmail.com, M: 9898277156. S. K. Patel Institute of Management and Computer Studies, Sector 23, Gh-6 Road, Gandhinagar, Gujarat. P: (079) 232 45735, 232 45729 Ext.: 122, 123 Dr. Chinnam S. Reddy is a Professor and Director - MBA, Marwadi Education Foundation Group of Institutions, M: 9727778190. Rajkot-Morbi Road, At & PO: Gauridad 360 003. Tal. & Dist: Rajkot. Gujarat. P: 0281 2923112 GITAM Journal o f Management Vol. 12 No.2 pp227-237 Apr-June 2014 © 2014 GIM, GITAM Real Option Analysis Using Black Scholes Model PRAKASH M. CHAWLA AND CHINNAM S. REDDY Real options valuation is a financial technique for evaluating investments under conditions of uncertainty, particularly uncertainty associated with market variables such as future product demand or the future value of an asset. Option pricing is a well-developed area of financial engineering, dealing with the valuation of puts, calls etc., but it is understood as a real option, when it is applicable to real assets like building, plant & machinery etc. Real option analysis has become imperative to capture the value of a company due to future growth from new product variations, expamion of capacity for existing products. Black Scholes model of option pricing is able to use variables like volatility, exercise price to predict value of a given situation. In this paper, we exp/on' the existence of options in business decisions. It will have a small introduction to options, detenninants of option pricing and the basics of option pricing. This paper would use Black Scholes model to find real option values in a given situation of a product/service and interpret to understand its importance & implications on the future of the given situation.