Sunday, September 13, 2009

Real Options In Practice

Rarely, a book of immense breadth comes along so little understood by its publisher that it is launched as a technical manual for industry insiders when, in fact, it is a seminal work in many fields. Marion A. Brach, a physician with a background in medical research and a deep understanding of mathematics, migrated to finance. She took an interest in real options, which is the field of valuation of choices in the real as opposed to the financial world and in due course produced her book.

Dr. Brach's interest is, at its core, whether X corporation should buy Y corporation or invest a known amount of money in a project. This sort of thing has usually been handled by discounted cash flow analysis. If Y can add a known amount of money to X's business, then the purchase price of Y must not exceed the discounted cash flow it brings in.

What's wrong with discounted cash flow is that it ignores risk, as Dr. Brach points out.That's a huge gap and one which real options can fix.



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