Real options in the financial decision making system. The Role of Real Options in Investment Decisions

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real options in the financial decision making system

Behaviour Driven Development and Test Driven Development provide many options, especially "the option to change the software, knowing when you have broken it.

In other words, test driven development removes the need for design commitments, the choice of design can be deferred until after the coding has started.

The Role of Real Options in Investment Decisions

More subtly, Test Driven Development allows the developer to know with certainty that they have finished, instead of determining beforehand when the programming is done. Test driven development requires no decision at all, simply stop coding when all the tests are green.

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Similarly mock objects allow the developer to defer the decision on how to implement a class until a later time when they have more information on what is required from the class. They also create a nice recursive implementation pattern. XP and Scrum defer the decision about which story to develop until just before the coding starts. This allows the team to incorporate information that arrives at the last moment, such as a new client request.

Jin Beans Real Option Decision

The Scrum Backlog provides a forum where any idea for functionality can be recorded without requiring an immediate commitment to build it. At the project Chris is working on, the development is prioritised based on client requests.

Real Options in Strategy and Finance

In effect, sales real options in the financial decision making system the prioritisation process by stating the relative importance of a client.

The team doesn't start working on a feature until the clients have requested it. Now the team waits to see what the clients actually request. By delaying commitment on the features built, the team is able to reduce time-to-market for new features requested.

When the client requests a feature the team is free to act, because they are not tied up working on unwanted features. This is only possible with short iterations and a fast turnaround on regression testing. Pairing provides options in that more than one developer will have an intimate knowledge of any part of the system. This mitigates the "truck number" a.

The truck number is the size of the smallest set of people in a project such that, if all of them get hit by a truck, the project would be in serious trouble [1]. By spreading the knowledge of the system the project is not in danger when anyone on the team wins the lottery.

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So What are Real Options? Real Options is an approach that allows people to make optimal decisions within their current context. This may sound difficult, but in essence it is a different view on how we deal with making decisions. There are two aspects to Real Options, the mathematics and the psychology.

Next Section They are called real options because they are investments in tangible assets, products, processes, and services rather than financial instruments such as stocks. For financial investments, option-pricing techniques are heavily used to take into account the flexibility issue. The most popular is the Black—Scholes option-pricing model where the option value is determined by five input values of the exercise price of an option, the time to exercise date, the current price of the asset, the variance per period of rate of return on asset, and the risk-free rate of interest.

The mathematics of Real Options, which is based on Financial Option Theory, provide us an optimal decision process [2]. The psychology of uncertainty and decision making based on Neuro Linguistic Programming [3][4] and Cognitive Behavioural theory tells us why people do not follow this optimal decision process and make irrational decisions as a result. Financial options are options written and stock and shares.

A huge amount of mathematics has been developed to price and risk manage these options. Real Options are real world decisions.

So What are Real Options?

Much of the existing literature explains how we can use the Black Scholes formula to price real options. Fisher Black and Myron Scholes along with Robert Merton are Nobel Prize winning economists who invented an equation to value financial options. Unfortunately, most of that literature is wrong when applied to Real Options.

real options in the financial decision making system

We cannot price real options using Black Scholes' famous equation. Whereas a PhD or Masters in financial mathematics is required to derive Black Scholes or prove the statement we just made, no understanding of maths is required to use the results of these maths.

The "only" things that the Financial Option maths can tell us about options are: Options have value.

real options in the financial decision making system

Options expire. Never commit early unless you know why. Quite simply, the maths tells us not to make a commitment until the last minute unless we know with certainty why we want to make the decision early.

real options in the financial decision making system

Sound familiar? The "Real Option" decision process is not new.

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Preston Smith was one of the first to coin the phrase "Make the commitment at the last responsible moment" [5]. However, whereas Preston's statement was an opinion based upon many observations, Real Options are based on financial mathematics. In the Summer ofwe ran a series of sessions on Real Options.

Without understanding the psychology, most attempts to implement a new decision process will fail. Choices Given any decision to be made, there are three possible decision categories, namely, a "right decision", a "wrong decision" and "no decision".

real options in the financial decision making system

Most people think there are only two; you're either right or you're wrong. As we normally do not know which is the right or wrong decision, the optimal decision is in fact "no decision" as this defers the commitment until we have more information to make a better informed decision. However, if we observe the behaviour of most people, we notice that an aversion to uncertainty means people make decisions early.

Real Options address this aversion earnings on the Internet for a programmer uncertainty by defining the exact date or conditions to be met before the decision should be made. Instead of saying "not yet", the Real Option approach says "Make the decision when This gives people certainty over when the decision is made and as a result they are more comfortable with delaying the decision.

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Delaying commitments gives decision makers more flexibility as they continue to have options. Real Options feels unnatural to begin with.

Viewing Agile through Real Options

Like leaning down the hill when skiing, or leaning back when you jump from a height on horseback. Real options in the financial decision making system few people adopt them naturally. Others need a coach, time and practice to get it.

real options in the financial decision making system

Perhaps like Agile? Perhaps the "unnatural" feel of this uncertainty one of the reasons that some people are so opposed to Agile. Rather than decisions, Real Options is really about commitments. Quite often people make a decision which becomes an emotional commitment to an idea.

Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example". Consider a firm that has the option to invest in a new factory.

They do not realise that they can change their minds. Is agreeing to go to out with a friend an option or a commitment?