Use of Real Options Theory in Financial Management/Modeling

Use of Real Options Theory in Financial Management/Modeling

Introduction

The main purpose of this paper is to make an analysis of the use of real options theory in Financial Management/Modelling. Real Option theory is a very important theory which has been recently developed for the purpose of making the investment decisions. The Real Option theory is the modification of the traditional Expect Net present Value theory of investment decisions. The theory of options is purely financial in origin, is widely used as hedging strategy for investments in securities or shares and there are even options on the price movement of various financial assets such as currencies or stock market index.

Discussion

The extension of the theory of arbitrage pricing of derivative assets (assets traded), known as the theory of real options, is a path that was used to evaluate certain assets or investments when calculating traditional economic proved inadequate. This theory allows taking into account the dynamics of investment decisions and, in particular, irreversibility and the possibility of different choices. The method consists in measuring the optional aspects contained in a decision making process (Amram, 1999). Option decision is treated as a derivative asset that is valued by arbitration. The real options theory has been applied to the types of problems such as copper mining, oil drilling, etc., which is necessary for a relationship between an active (on future copper on oil) and to assess the risk . However, in many application domains there is no active negotiated which is connected, obviously, to assess the risk.

In the case of a real option, the theory invokes a strong causal relationship on the basis of "evidence" economic, between the active and evaluate assets traded. This relationship "natural" is then formalized as a functional relationship between payments to assess risk and those of the underlying asset from the observed data. For example, it is "obvious" that future payments of a copper mine (X) depend on the future price of copper (S). This evidence can be estimated from observed data a functional relationship (f) between X and S of the form X = f (S).

This paper focuses on the use of Real Option theory in the financial management/modelling in the real life practice.

Identification of the Main Issues

I have been working in a financial management company as the Assistant Manager Finance. My job was to determine the financial functions related to the investment decisions. The company wanted to make the investment decisions in an effective manner (Quigg, 1993). The company was facing different problems in making investment decisions and was unable to make the successful investment decisions. Therefore, the company has developed different approaches for the purpose of dealing with the different investment problems. One of the financial managers of the company has proposed the use of real Option theory. Therefore, in order to make the investment decision, the company has used the real option theory which is the opportunity used by my company in order to have an ...