The Gap between Real Options Theory and Practical Application

Document Type:Essay

Subject Area:Finance

Document 1

However, it should be realized that factoring real options impact business investments valuation due to potential market, technological, and economic conditions. However, there has been an issue regarding if the real options theory meets the real options practice. Therefore, this report has focused on evaluating the work of Mathews et al. (2007) and Triantis (2005) to come with concrete evidence that indeed real options theory mirror the practical applications of real options. The Gap between Real Options Theory and Practical Application Triantis has provided real options concepts and techniques in finance and economics. Triantis came up with certain concepts that would help bridge the existing gap between theory and practice. His five themes were influenced by two particular critiques of real options practicality.

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Triantis refers to his themes as the five key challenges that will need to be looked at and addressed by future researchers’ on real options. This will improve the practice of using real options in decision making. One important critique of real options argues that the real options models indicate perfection instead of the economic reality. Five critical challenges Discovered by Triantis The first theme by Triantis is that there is a need for refining the models of perfection. For instance, the underlying asset in the majority of the real options models is assumed to be traded in liquid markets with its price known to interested investors. The assumption that each option is viewed as different from those in other securities in one’s portfolio is not appropriate in real option as it is appropriate for other financial options.

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The problem with real options is that there lacks consistent guidance on the way to calculate clean estimates for the discounting rates for the projects. This makes it difficult to calculate the risk associated with a particular project using real option (Triantis, 2005). The main objective of the Boeing approach is to develop a real option strategy that adopts the framework of DCF analysis. Managers are already familiar with the DCF analysis approach and prefer its use. This has led to a method of valuing real options referred to as the Datar Mathews real options (DM) method. It is similar to the Black-Scholes algebraic formula used in valuing financial options. The DM method uses information that comes up naturally in a normal Discounted Cash Flow (DCF) project financial valuation (Mathews, Datar, Johnson, 2007).

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Majority of the models that support ROA are academia and theoretical research. This has made people continue to ignore and lack an understanding of real options. Few numerical and analytical solutions can indicate the use of ROA in actual practice. This is due to their difficulty that is associated with calculating partial differential equations that rely on certain parameters to exist (Haque et al. This shows that people are still unwilling to try real options in making decisions. This also happens to corporate boards and thus renders the approach us too technical. However, the Mathews approach is transparent and straightforward. This is a major advantage that addresses the complexity identified by Triantis. The Datar-Mathews (DM) method makes the real options approach to rely on a wide variety of information that is generated in scenario planning discussions.

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This makes the ROA approach simple and flexible (Mathews, Datar, Johnson, 2007). The ROA is mostly theoretical and lacks significant support from practical evidence (Schulmerich, 2010). This challenge is solved by the DM method that has superior computational methods that can provide a more realistic value for investments. Complex computations are also important in addressing the second challenge of splitting options. The third challenge that is addressed by the DM method is the modeling of management behavior. Triantis had noted that the gap between real theory and practice exists because management behavior and judgment are unpredictable and based on cognitive skills. References Haque, M. , Topal, E. , Lilford, E. A numerical study for a mining project using real options valuation under commodity price uncertainty.

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