Reading: Implementing Real Option Valuation

The first question is whether there is an option embedded in an asset or decision.

Options provide the holder with the RIGHT to buy (call option) or sell (put option) a predefined quantity of a predefined asset at a predefined price at (or until) a predefined point in time.

This implies, among other things:

1. Right vs. obligation: The holder of the option can choose whether to exercise the right (buy or sell the asset). Put differently, the option holder can postpone an investment (divestment) decision to a future point in time. The seller (issuer) of the option, in contrast, will then have the obligation to deliver the asset (or purchase it in the case of a put option) if the holder exercises his right. Consequently, an option always gives asymmetric rights to the holder an the issuer. 
   • For example, a contract in which the parties agree to exchange an asset at a predefined price in the future is not an option, simply because none of the parties will have a choice in the future. 
   • Similarly, an agreement to meet again in the future to negotiate a business transaction is not an option because it does not allocate asymmetric rights to the parties (both parties will be able to decide whether or not the negotiated deal is attractive to them). 
2. The underlying asset has to be clearly defined and its value must change in unpredictable ways. 
3. The cost of exercising the option must be known and fixed today. The right to buy an asset at its future market value, for example, does not constitute a real option.
4. The payoffs of the real option have to be contingent on specific events that occur during the lifetime of the option.