Real options

Alain Bensoussan (University of Texas, Dallas)

Real Options theory is an approach to mitigate risks of Investment projects, which is based on two ideas. The first one is Hedging, borrowed from financial options, when market Considerations can be introduced. The project risk must be correlated to the market risk, in which case tradable assets can be used to hedge. The second idea is flexibility. There is flexibility in the process of decision making. In particular, one may scale down or up the project, one may stop it, one may change orientation. This flexibility allows reacting properly when iInformation is obtained on the uncertainties of the evolution.We review in this presentation some of the major possibilities of flexibility, to defer, to abandon, mothballing. We also consider some extensions on the investment cost, for instance the situation of tax incentives. We show that the technique of Variational Inequalities is the right mathematical tool to model these situations. The models are developed in continuous time, where the elegant rules of Ito’s calculus apply. The concepts are discussed independently of these techniques.