Hostname: page-component-78c5997874-m6dg7 Total loading time: 0 Render date: 2024-11-04T20:23:26.353Z Has data issue: false hasContentIssue false
  • English
  • Français

The Nature of Option Interactions and the Valuation of Investments with Multiple Real Options

Published online by Cambridge University Press:  06 April 2009

Lenos Trigeorgis
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper deals with the nature of option interactions and the valuation of capital budgeting projects possessing flexibility in the form of multiple real options. It identifies situations where option interactions can be small or large, negative or positive. Interactions generally depend on the type, separation, degree of being “in the money,” and the order of the options involved. The paper illustrates, through a generic example, the importance of properly accounting for interactions among the options to defer, abandon, contract or expand investment, and switch use. It is shown that the incremental value of an additional option, in the presence of other options, is generally less than its value in isolation, and declines as more options are present. Therefore, valuation errors from ignoring a particular option may be small. However, configurations of real options exhibiting precisely the opposite behavior are identified. Comparative statics results confirm that the value of flexibility, despite interactions, manifests familiar option properties.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 28 , Issue 1 , March 1993 , pp. 1 - 20
Copyright
Copyright © School of Business Administration, University of Washington 1993

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Abramowitz, M., and Stegum, I.. Handbook of Mathematical Functions. (National Bureau of Standards, Washington D.C.) New York, NY: Dover Publications (1972).Google Scholar
Baldwin, C., and Ruback, R.. “Inflation, Uncertainty, and Investment.” Journal of Finance, 41 (07 1986), 657–669.CrossRefGoogle Scholar
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (05/06 1973), 637–659.CrossRefGoogle Scholar
Brennan, M. “The Pricing of Contingent Claims in Discrete Time Models.” Journal of Finance, 34 (03 1979), 53–68.CrossRefGoogle Scholar
Brennan, M., and Schwartz, E.. “Evaluating Natural Resource Investments.” Journal of Business, 58 (04 1985), 135–157.CrossRefGoogle Scholar
Carr, P. “The Valuation of Sequential Exchange Opportunities.” Journal of Finance, 43 (12 1988), 1235–1255.CrossRefGoogle Scholar
Constantinides, G. “Market Risk Adjustment in Project Valuation.” Journal of Finance, 33 (05 1978), 603–616.CrossRefGoogle Scholar
Cox, J., and Ross, S.. “The Valuation of Options for Alternative Stochastic Processes.” Journal of Financial Economics, 3 (01 1976), 145–166.CrossRefGoogle Scholar
Cox, J.; Ingersoll, J.; and Ross, S.. “An Intertemporal General Equilibrium Model of Asset Prices.” Econometrica, 53 (1985), 363–384.CrossRefGoogle Scholar
Cox, J.; Ross, S.; and Rubinstein, M.. “Option Pricing: A Simplified Approach.” Journal of Financial Economics, 7 (09 1979), 229–263.CrossRefGoogle Scholar
Geske, R. “The Valuation of Compound Options.” Journal of Financial Economics, 7 (1979), 63–81.CrossRefGoogle Scholar
Geske, R., and Shastri, K.. “Valuation by Approximation: A Comparison of Alternative Option Valuation Techniques.” Journal of Financial and Quantitative Analysis, 20 (03 1985), 45–71.CrossRefGoogle Scholar
Harrison, J. M., and Kreps, D. M.. “Martingales and Arbitrage in Multiperiod Securities Markets.” Journal of Economic Theory, 20 (1979), 381–408.CrossRefGoogle Scholar
Hull, J.Options, Futures, and Other Derivative Securities. Englewood Cliffs, NJ: Prentice-Hall (1989).Google Scholar
Jarrow, R., and Rudd, A.. Option Pricing. Homewood, IL: R. D. Irwin (1983).Google Scholar
Kester, W. C. “Today's Options for Tomorrow's Growth.” Harvard Business Review (03/04 1984), 153–160.Google Scholar
Majd, S., and Pindyck, R.. “Time to Build, Option Value, and Investment Decisions.” Journal of Financial Economics, 18 (03 1987), 7–27.CrossRefGoogle Scholar
Margrabe, W. “The Value of an Option to Exchange One Asset for Another.” Journal of Finance, 33 (03 1978), 177–186.CrossRefGoogle Scholar
Mason, S. P., and Merton, R. C.. “The Role of Contingent Claims Analysis in Corporate Finance.” In Recent Advances in Corporate Finance, Altman, E. and Subrahmanyam, M., eds. Homewood, IL: R. D. Irwin (1985).Google Scholar
McDonald, R., and Siegel, D.. “Option Pricing when the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note.” Journal of Finance, 39 (1984), 261–265.Google Scholar
McDonald, R., and Siegel, D.. “Investment and the Valuation of Firms when There is an Option to Shut Down.” International Economic Review, 26 (06 1985), 331–349.CrossRefGoogle Scholar
McDonald, R., and Siegel, D.. “The Value of Waiting to Invest.” Quarterly Journal of Economics, 101 (11 1986), 707–727.CrossRefGoogle Scholar
Myers, S. C. “Finance Theory and Financial Strategy.” Midland Corporate Finance Journal, 5 (Spring 1987), 6–13.Google Scholar
Myers, S. C., and Majd, S.. “Abandonment Value and Project Life.” Advances in Futures and Options Research, 4 (1990), 1–21.Google Scholar
Paddock, J.; Siegel, D.; and Smith, J.. “Option Valuation of Claims on Physical Assets: The Case of Offshore Petroleum Leases.” Quarterly Journal of Economics, 103 (08 1988), 479–508.CrossRefGoogle Scholar
Stulz, R. “Options on the Minimum or Maximum of Two Risky Assets: Analysis and Applications.” Journal of Financial Economics, 10 (07 1982), 161–185.CrossRefGoogle Scholar
Tourinho, O. “The Option Value of Reserves of Natural Resources.” Working Paper, Univ. of California at Berkeley (1979).Google Scholar
Trigeorgis, L. “Valuing Real Investment Opportunities: An Options Approach to Strategic Capital Budgeting.” Unpubl. Doctoral Diss.: Harvard Univ. (1986).Google Scholar
Trigeorgis, L. “A Conceptual Options Framework for Capital Budgeting.” Advances in Futures and Options Research, 3 (1988), 145–167.Google Scholar
Trigeorgis, L. “A Real Options Application in Natural Resource Investments.” Advances in Futures and Options Research, 4 (1990), 153–164.Google Scholar
Trigeorgis, L. “Anticipated Competitive Entry and Early Preemptive Investment in Deferrable Projects.” Journal of Economics and Business, 43 (05 1991a), 143–156.CrossRefGoogle Scholar
Trigeorgis, L. “A Log-Transformed Binomial Numerical Analysis Method for Valuing Complex Multi-Option Investments.” Journal of Financial and Quantitative Analysis, 26 (09 1991b), 309–326.CrossRefGoogle Scholar
Trigeorgis, L., and Kasanen, E.. “An Integrated Options-Based Strategic Planning and Control Model.” Managerial Finance, 17 (05 1991), 16–28.CrossRefGoogle Scholar
Trigeorgis, L., and Mason, S. P.. “Valuing Managerial Flexibility.” Midland Corporate Finance Journal, 5 (Spring 1987), 14–21.Google Scholar