Friday, 2 November 2012

Real Options in Practice

  • Hardcover: 320 pages
  • Publisher: Wiley; 1 edition (November 8, 2002)
  • Language: English
  • ISBN-10: 0471263087
  • ISBN-13: 978-0471263081
Rarely, a book of immense breadth comes along so little understood by its publisher that it is launched as a technical manual for industry insiders when, in fact, it is a seminal work in many fields. Marion A. Brach, a physician with a background in medical research and a deep understanding of mathematics, migrated to finance. She took an interest in real options, which is the field of valuation of choices in the real as opposed to the financial world and in due course produced her book.
Dr. Brach's interest is, at its core, whether X corporation should buy Y corporation or invest a known amount of money in a project. This sort of thing has usually been handled by discounted cash flow analysis. If Y can add a known amount of money to X's business, then the purchase price of Y must not exceed the discounted cash flow it brings in.
What's wrong with discounted cash flow is that it ignores risk, as Dr. Brach points out.That's a huge gap and one which real options can fix.
The corrective value of real options pricing is obvious. The downside of real options is that it takes a good deal of math, usually partial differential equations, to do it. Financial calculators are alr eady available at modest prices to handle the Black-Scholes model of options pricing, but real options that involve corporate planning require a deeper sense of what the math is about. As Dr. Brach points out, a model for a deterministic solution, such as how much to pay for a right to buy a what contract that will expire at a known price, zero, at a given time, is different from the situation of a process that has a stochastic or even randomized outcome.
Dr. Brach moves her story and analysis from biblical accounts of grain trading and a developing and parallel options market and Joseph's choice of whether to save grain to guard against seven years of famine. Thales, the Greek philosopher, bought call options on olive presses well before a harvest and was able to raise press rents at the small cost of the options he bought.
The story of the development of real options moves from Greek olives to Dutch tulips and then to theories of thermodynamics. Dr. Brach mentions the roots of real options analysis in Russian and French investigations of probability theory, the use of Brownian motion as a foundation for stochastic theories of where prices will be in successive periods, and assumptions about market clearing and interest rates.
There are investigations of the value of learning and the reduction of noise, the applications of game theory to outcome analysis, and a consideration of where real options is going and where its usefulness may end. The strength of the book is its sweeping view of the field of the valuation of events, the clarity of Dr. Brach's writing, a fine19 page bibliography, and her ability to tell her story without delving into mathematical physics - the source of much of the analytic power of real options analysis.
For the investor, this value of this book about the analysis of non-financial options is what it says about the limitations of conventional investigations of future financial events. For thoughtful folks not concerned about figuring out the price of a financial options, Dr. Brach provides a glimpse of analysis as it will likely be in a decade or two. This reviewer cannot recommend this book too highly. For a reader with a little calculus and some statistics, it's not hard reading. For anyone, it is an adventure with a very bright mind-- Toronto Globe & Mail 

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