Real Options: Simple Example

The term “Real Option” refers to an additional decision possibility that is created in any real-life situation if the scope of the permitted decision alternatives is extended in some way.

Real options are most frequently discussed in the context of situations in which there is uncertainty. However, there is no requirement for uncertainty to be present, only that there is an additional decision possibility that has been created or could be made available for some reason (such as using higher quality decision processes that generate a good set of alternatives before deciding on one).

In the case of uncertain situations, value can be created either by:

  • Finding or creating a way to react to some uncertain outcomes (such as reducing the impact of bad outcomes or further exploiting good ones).
  • Seeking more information before making a final decision (which typically involves delaying the decision).

To take a simple example of the first point, you may be considering attending a training course, but you think that there is a high chance (70%) that it will not be useful to you. However, in the 30% of cases where it is useful, you would get a benefit of 30 (say in terms of improved work performance). On the other hand, if you stay at work instead of attending the course, then you will get a benefit of 10 units. On average, it will be better to stay at work (see image), and your decision situation is worth 10 (i.e. the benefit that you will get in this situation on average, if you may the right decisions). [Going to the course gives you an average benefit of 9, so is suboptimal compared to getting the benefit of 10 by staying at work].

However, if – in the case that the course is not useful – you would be able to do some work anyway (e.g. you either find out that there is an e-mail facility on the course computer, or you can create such a facility or equivalent alternative), then the decision structure is different. The image shows the case where you would be able to achieve a benefit of 5 in this situation. 

Note that the overall value of the situation is 12.5, and also that the optimal decision has switched to the one where you would attend the course. The “options” value is 2.5 i.e. the net benefit created by having this additional possibility.

This is a simple example of real options analysis, of which there are many variations. The topics is linked to many other subjects including decision making, optimisation, value of information, Bayesian analysis, as well as financial economics (discount rates, hedging, stochastic processes) and so on.

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