CAF Academic Fellow Eduardo Schwartz, California Chair in Real Estate and Land Economics, UCLA Anderson School of Management, was at ISB recently for the annual summer research conference. Just prior to his keynote on “The Real Options Approach to Valuation: Challenges and Opportunities,” he spoke with Professor Ramabhadran Thirumalai on real options, and their pricing.
Ramabhadran Thirumalai: You have worked extensively on Real Options. I know that you are one of the fi rst people to come up with the concept of Real Option pricing. Can Real Options introduce some kind of fl exibility in projects from a capital budgeting perspective? And valuing them is very critical because if Real Options are ignored then you mostly underestimate the net present value of the project. So, how does one go about identifying a Real Option? As a manager, how does one think about Real Options?
Eduardo Schwartz: There are two necessary conditions for Real Options. First, you have to have uncertainty about the future and second, you have to have flexibility. You must be able to change your mind as the world unfolds, as the world changes. Uncertainty, along with flexibility essentially, forms a Real Option. In other words, you have the possibility, for example, of abandoning a project if things don’t turn out well, that is flexibility. In traditional valuation methods we discount just one expected cash flow, the mean of the distribution. When we value Real Options we take the whole distribution of cash flows and we don’t have to produce, for example, if the cash flows are very low. We have the possibility of starting production or abandoning the project and so forth. Similarly, if the cash flows are very good we have the possibility of expanding the project. So flexibility and uncertainty are the basic elements for a Real Option problem.
Following up on the valuation part; we have a number of models to value the financial options, Black-Scholes, binomial trees, etc. Why can’t we use those to value Real Options and what are the challenges that one faces while valuing Real Options relative to financial options?
We do use the methodology from financial options to value Real Options. But very soon the problems become different. When you value financial options, you typically know the stochastic process of the underlying asset. If you value an option on bonds, you have a process for the interest rates. If you value options on stocks, you have a process for stock prices. If you value an option on commodities, you have a process for commodity prices. Sometimes when you value Real Options, the underlying uncertainty is not a traded asset, so valuation becomes more complex.
However, this result really applies up to five years where we have data, while copper mines can last through 60 years. How do I know that the curve will fit the prices well from five to 50 years?
I distinguish three types of Real Options problems – one, in which the underlying process is well known and the risk-neutral process is known. We have only one situation in nature where this is known and that would be for gold mines. This is because the stochastic process for gold prices is very similar to the stochastic process for stock prices. The second case is when we don’t know the risk-neutral distribution but we obtain it from futures prices or other traded assets. This would apply to copper mines, silver mines, and oil deposits. We have futures prices of these commodities and therefore we can obtain the risk-neutral distribution for Real Option pricing. And the third case is where the underlying variables are non-traded assets.
To illustrate this, I will speak on how to value research and development investments, with a focus on the pharmaceutical industry. At least in the simple problems the uncertainty first is about the cost to completion of the project. Once you start an R&D project in the pharmaceutical industry you don’t know how long it will take to complete the project – it can take from four years to 15 years. And second, you don’t know how much you will spend. On an average you would spend about $4 billion. But this can take a wide range of values. So in this case, one of the underlying uncertainties is the cost to completion. And the second uncertainty has to do with the cash flows generated by the project when you finish the investment. For the cash flows I tried to figure out some traded asset related-cash flows because in the pharmaceutical companies’ trade, one can obtain the betas of the stocks and from them, the risk neutral distributions. So that is an example when Real Option valuation is much more complex. And in those cases, that is my third case, I usually say that, in addition to solving the Real Option problem, we also need to find the risk-neutral distribution. You need an equilibrium model like the Capital Asset Pricing Model. So these types of problems are different.
In most classes we teach that speculative forces, instead of producing more volatility, will reduce the volatility. So as a policy, unless there are people who are taking very large positions or they are cornering the market, I think that allowing for future trading is positive.
So, would futures on electricity or weather be something similar to what you are talking about?
Yes, when the underlying asset is not well-known or does not follow a process that we can define. For weather, we can try to figure out a process. But you cannot find a process for the cost to completion and other things such as the clarity of the research output. So the techniques that we use in Real Options come directly from contingent claim analysis of a financial security. But it is applied to value real projects as opposed to financial projects.
There is a lot of research on how to value Real Options. Do you have a sense of whether businesses today try to identify and value Real Options? Do businesses take Real Options really seriously and do you have a sense of how widespread the use of Real Options is?
I am more experienced in the mining industry. And I know that mining companies take it very seriously and many of the big companies use Real Option valuation. I don’t know of other companies but I do know that many consulting companies do form Real Option groups to try to value these. There are two ways of dealing with Real Options – one, to try to really value Real Options and determine the right moment to invest in a corporation. And that is what I try to do. I do the technical part. People in policy and other areas have used Real Options more conceptually. They say, “Well, we have this situation but we have all these options,” and they have to have values but they don’t determine the exact value. It is more like a framework rather than a methodology to actually value the projects.
So it is more like an ad-hoc value than real value
At least in concept their value is more than the future cash flows because you have the flexibility and that has to have a value. We say that it has to have a value, so let us try to find the value. I have done more of the technical valuations because I come originally from a background in financial options – that was my first work bout 38 years ago.
You have already mentioned a few sectors where Real Options are used. You have mentioned mining. You have also mentioned pharmaceutical in terms of R&D. Are there any other sectors that are more likely to have Real Options?
Many years ago, I worked on valuing Internet companies by using Real Options. I have worked on valuing information technology projects. I have also done some work on valuing forestry resources. And there are other people who have worked on other aspects. One of the interesting parts of the Real Options method is that it has expanded in different directions. One of the directions in which it has expanded, and I will be talking a little about that in the keynote, is taking into account competitive interactions. Instead of valuing one project on its own, what happens if I have two pharmaceutical companies trying to develop the same drug, something to cure, for example, Alzheimer’s disease? So in that case the exercise of my options depends not only on my variables but on the variables affecting my competitors. So it is a combination of Real Options and game theory. I have one paper dealing with that and I will mention it in the keynote talk. And there are people expanding Real Options in other ways. Most of the Real Options problems that I deal with assume symmetric information. But we know that in the world that there are information asymmetries. So you can expand that to include information asymmetries. In other words people have been trying to expand Real Options to take into account all the factors that we take for granted.
Speculators will see this as an opportunity because they see this is really abnormal and during harvest time, there will be enough buyers.
What do you think are the common pitfalls that companies need to be aware of while valuing Real Options? There might be some trap, where management or a company executive may say, “Well, this is an easy way out but we should not do it because then we will mis-value the Real Option.”
If you noted, the title of my talk is “The Real Options Approach to Valuation: Challenges and Opportunities” because the challenges I have observed come from my practical application of these concepts. Let me give you one specific point that I am working on because it is an important one. To be able to value, for example a copper mine, I have to first fit a stochastic process for futures prices. Well, it turns out that I have a maximum of five years of data on copper futures prices. So I have shown that the model fits the data, the futures prices, very well up to five years. Sometimes the futures curve is in contango, where the futures prices are above the spot prices, and sometimes spot prices are above futures prices. The models are so good that they fit both the futures prices and the dynamics of the futures curve well – that is how the curve moves over time. However, this result really applies up to five years where we have data, while copper mines can last through sixty years. How do I know that the curve will fit the prices well from five to 50 years? That is a big challenge, a challenge that practitioners are worried about.
This is a little technical; the one factor that we cannot estimate well when we estimate stochastic commodity models is the risk premium. The reason is because we have a number of series of futures prices so we can estimate the risk neutral distribution very well but we only have one time series of the real prices. Let us say that the difference between the five-year futures price and the expected spot price in five years is the risk premium. We cannot estimate this risk premium very well. This doesn’t matter if you have to value an option up to five years because you don’t care about the true process. You care about the risk-neutral process. But what happens to your pricing of a mine that will be around for 50 years into the future. In that case, you want the futures price to be reasonable. We are trying to get the risk premium using an asset pricing model such as the Capital Asset Pricing Model. So it is a little weak there because we need an asset pricing model but if we want a good estimate of the risk premium we use that. We estimate the risk premium and show that some of the parameters change a little. But the estimation of the futures curve doesn’t change at all. In other words we get a more reasonable estimation of the curve and that will allow us to have more confidence in the future.
So, many problems associated with Real Options is due to the challenges with the horizon, how long is the Real Options going to last and most of the Option pricing models and methodologies are more short term because —-
When I made my presidential address to the American Financial Association I got data from Enron. They had data for nine years for oil futures. They gave me access to a proprietary database. That was a little longer time-series of data. I would say that it is long term but it is also an estimation of the risk premium. You see, for most applications of options you want to know the risk-neutral process. But what if you want to do value at risk? If you want to do value at risk, you are interested in the true process rather than in the risk-neutral process. And therefore, the risk premium becomes an important factor for risk management.
That is interesting. Moving away from Real Options, I have a policy-related question. Frequently in India, any time the volatility in the commodity prices spike, the government immediately steps in and bans commodity futures in what they call essential agricultural commodity derivatives. It could be rice or wheat, which the government thinks is essential to people’s every day needs. So they ban trading in the commodity derivatives and one of the main reasons that they give for banning these commodity derivatives is that they want to reduce or control the volatility to excessive speculation. Do you think that from a policy perspective, banning commodity derivatives periodically is a good idea to control volatility?
I agree that you have to regulate cornering in the markets. Somebody can’t buy too many of the securities. There should be limits to the amount, position limits I think are reasonable. You don’t want somebody to have too much control. Apart from that, my belief is that trading in these instruments reduces volatility as opposed to increasing volatility. Who wants to hedge and who wants to short the future contracts?
They are the producers – because, if I produce wheat I want to sell my products in the futures market. Who wants to buy wheat in the futures market? They are the bakeries that buy the wheat to make bread or they buy for some other purpose. I am thinking about the US, where people are the users. The demand for the futures will come from the users; the supply of futures comes from the producers. What happens when there are not enough consumers in the market and too many people want to sell? This means that the price will go down. But speculators will see this as an opportunity because they see this is really abnormal and during harvest time, there will be enough buyers. So they will take the opposite position.
You can make money by taking the opposite position. In most classes we teach that speculative forces, instead of producing more volatility, will reduce the volatility. So as a policy, unless there are people who are taking very large positions or they are cornering the market, I think that allowing for future trading is positive. And you have to see the other institutional factors that exist. But in general, my idea is that speculation is good for both sides and for the volatility of the market because you have another force that will try to profit when prices are too high or too low.