Explain How the Real Options Method Using Stock Options

Question

Examlex · Accepted Answer

The Answer is To understand real options,it is first useful to consider the financial model upon which they are based-stock options.In "real options," the assets underlying the value of the option are nonfinancial resources.An investor who makes an initial investment in basic R&D or in breakthrough technologies is,it is argued,buying a real call option to implement that technology later should it prove to be valuable.With respect to research and development:
The cost of the R&D program can be considered the price of a call option.
The cost of future investment required to capitalize on the R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price.
The returns to the R&D investment are analogous to the value of a stock purchased with a call option.
One drawback is the fact that technology investment scenarios often do not conform to the same capital market assumptions upon which the approach is based.Furthermore,while the value of a stock is independent of the call holder's behavior (that is,the call holder can simply wait and observe whether the value of the stock rises or falls),the value of an R&D investment is not independent of the investor's behavior.

Explain How the Real Options Method Using Stock Options

Definitions: