A QUICK GUIDE TO REAL OPTIONS/UNA GUIA RÁPIDA A LAS OPCIONES REALES

Real Options are financial options traded OTC whose underlying asset is a business operation; not shares, not raw materials...

Falling into the family of american styled options/Cayendo dentro de la familia de opciones al estilo americano...

Las opciones reales son opciones financieras transadas cara a cara y a la medida cuyo activo subyacente es una operaciòn de negocio; no acciones, no materias primas...Commonly used, three types of real options/Comúnmente usadas, tres tipos de opciones reales:

1. Option To Invest/Opción De Invertir: 
*A call option/una opción de compra
*Exercise Price/Precio De Ejecución: The up-front investment required when you decide
  to go ahead with the project/ El monto desembolsado de contado y mìnimo    
  necesario para iniciar operaciones.
*Value Of The Underlying Asset/Valor Del Activo Subyacente: Present Value of the net
  cash flows from operating the project/ Valor Presente de los flujos de caja netos de la             operación del proyecto.
*Premium/Prima:  What was/will be necessary to spend to establish the option (licenses,   
  legal paperwork, fares) / Lo que fue o será necesario gastar para establecer la opción   
  (licencias,  papeleo y tarifas de tramitación)


2. Option To Expand/Opción De Expandir:
*A call option/una opción de compra
*Exercise Price/Precio De Ejecución: All of the costs involved in the expansion/Todos los 
  costos involucrados en la expansión.
*Value Of The Underlying Asset/Valor Del Activo Subyacente: Present Value of the incremental net cash flows from expanded operations/Valor presente de los flujos de caja incrementales netos de las operaciones expandidas.
*Premium/Prima:  What was/will be necessary to spend to establish the option (empty space purchase, licenses, legal paperwork, fares) / Lo que fue o será necesario gastar para establecer la opción (espacio vacío, licencias,  papeleo y tarifas de tramitación)

3. Option To Abandon Operations/Opción De Abandonar Operaciones:
*A put option/una opciòn de venta*Exercise Price/Precio De Ejecución: The salvage value of the assets that can be sold upon 
  abandonment/El valor de salvamento de los activos que pueden ser vendidos antes de la 
  fecha del abandono total.*Value Of The Underlying Asset/Valor Del Activo Subyacente: Present Value of the net 
  cash flows from continued operations/Valor presente de los flujos de caja netos de 
  proseguir con las operaciones. 
*Premium/Prima:  What was/will be necessary to spend to establish the option (taxes, fines,   legal paperwork, fare) / Lo que fue o será necesario gastar para establecer la   
  opción (impuestos, multas,  papeleo y tarifas de tramitación)


EXAMPLES:
The present value without the option is $10 million, the present value of the
decision tree with the option is $12 million and the cost of expansion is $2m to be paid in 5 years. The discount rate is 10% per annum. What is the exercise price of the embedded option?
Answer: $2 million (simply, the PV of CAPEX to expand)

The present value with the option is $10 million, the present value of the decision tree without the option is $8 million and the estimated salvage value of assets is $2m to be received in 5 years. The discount rate is 10% per annum.   What is the option's premium ?
Answer: $2 million (10-8)
The present value of the decision tree without the option is $9 million, the present value of the decision tree with the option is $11 million and the cost of expansion is $1m to be paid in 5 years. The discount rate is 10% per annum. If the up-front payment required is $11.5m with the option embedded or $8.5m without the embedded option – what would your investment decision be?
Answer:  Invest in project without embedded option (10-11.5 = -0.5  but on the other hand 9-8.5= 0.5)

Five years ago,  "Magenta nipples Ltd"  purchased a block of land to establish manufacturing operations. They spent $1.2 million for the 4 acres of land, which was significantly larger than what they needed to conduct operations at the time. In fact they could have gotten away with spending only $800,000 on a smaller parcel of land. Now they are considering building a new factory on the site in response to an increase in demand for their product. It will cost them $300,000 to construct the new buildings on the previously unused part of their land parcel.

 What was the price paid for the option? $400.000 (1,200,000-800,000)

What is the exercise price of the option? $300.000  (present value of the cost to expand)

Acknowledgements: Sean Pinder & Paul Kofman from The University Of Melbourne
Sources: Bank Of New York-Mellon, Wikipedia, Coursera.org