FAQ Number 1

Is the Real Options Premium Important?

First the definition of real options premium:

Real Options Premium = Real Options Value - NPV

Answer with an analogy: Investments can be viewed as call options.

NPV = V - I

The options premium can be important or not, depending of the of the project moneyness

Looking the call option chart is possible to see that, for high project value, the option become deep-in-the-money so that the option premium become zero at the point A in the picture. The point A is the threshold level which is optimal the immediate option execise.

For moderate project values, as showed in the picture, the option premium can be very important, and even higher than the NPV itself. For out-of-money-projects, the option value is the only cause of a positive value for the investment opportunity.

What is the most frequent moneyness situation?
In general moderate value project are more frequent, although the fewer "deep-in-the-money" projects demand more attention for the corporations due to their attractiveness. But even out-of-money projects integrate a corporate portfolio of projects.
Hence, the answer to the FAQ is yes, except for "deep-in-the-money" projects.

Go to the Next FAQ: 2) What are the effects of interest rate, volatility, and other parameters in both option value and the decision rule?

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