The analogy of real options to financial options

Abstract

The real options literature has demonstrated the analogy between decisions concerning real investment opportunities and those concerning financial options. The role of the underlying uncertainty, irreversibility, and time flexibility are very similar in both cases. For a decade immediately after the appearance of the option pricing model, developed by Fischer Black, Robert Merton, and Myron Scholes in 1973, its idea had fascinated a number of researchers and there has been a number of studies using the option pricing technique to solve the valuation problems of various financial instruments such as debentures, convertible bonds, warrants, stocks, and insurance contracts. In the 1980s, the applications of option pricing started to expand beyond the limit of financial instruments to include some economic problems that have the option-like structure. Using the new methods and techniques to find the solutions of the Black and Scholes’ partial differential equation, this paper presents the analogy of the real options to the financial options.