The word option is a synonym for choice—the ability to do something or not do something in the future, at your discretion. Financial options are common. The most familiar are stock options, which are traded, e.g., on the Chicago Board Options Exchange (CBOE). The prices of these options can be looked up on Yahoo!Finance. Some options are traded over the counter: if you want to purchase a 10-year option on the Sony, chances are that you would have to ask someone—typically an investment bank—to manufacture such an option for you. Other financial options are embedded in contracts and securities. For example, your mortgage contract more than likely gives you the option to pay off the mortgage at your discretion, which you should do (and refinance) if interest rates drop enough. Your car insurance liability may have a deductible, which de facto means that the insurance is only an option that gives you the right to exercise it if the damage exceeds the deductible.
But this series of posts is not so much interested in financial options as it is in real options. What is the difference? A real option differs from a financial option in that the exercise of the real option requires a change in the physical, “real” project. Such real option projects can be factories, buildings, R&D activities, and so on. The most prominent real options are
Timing Your ability to start or stop a project at a time of your discretion. Abandoning Your ability to abandon a project at a time of your discretion. Accelerating Your ability to speed up a project at a time of your discretion. Expansion Your ability to expand a project at a time of your discretion. Switching Your ability to switch to a different technology.
Real options are difficult to value, but no one would argue that this means that you can ignore them. In fact, valuing real options is often more important than getting the discount rate right. You have no alternative but to give it your best shot.