“Real Options” are a powerful tool for guiding decision making in the presence of uncertain cost and uncertain value. They are a natural tool for Project Portfolio Management

1. 1
Notes on Real
Options
Glen B. Alleman, VP Program Management
“Real Options” are a powerful tool for guiding decision
making in the presence of uncertain cost and uncertain
value.
They are a natural tool for Project Portfolio Management

2. 2
What is a “Real Option?”
An option is the right, but not the
obligation, do something (usually buy or
sell some asset) at some time in the future
after learning about uncertainty
The source of uncertainty is called the
underlying
A real option is an option where the
underlying is not traded in the financial
markets

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Who Uses “Real Options”
In business areas with a high degree of
uncertainty, management, knowingly or
not, creates and exercises real options on
a regular basis.
R&D creates real options: management has
the right, but not the obligation, to
commercialize the results.
In decision tree notation – real options are
represented by "downstream" decisions
Decision nodes which follow one or more
chance nodes.

4. 4
Strategy is a Portfolio of Real Options
In financial terms, strategy is similar to a
series of options than a single plan based
process
Executing a strategy involves a sequence
of decisions
Some actions a taken immediately
Some actions are deferred

5. 5
How are “Real Options” quantified?
Methods from financial option pricing
theory, such as the Black Scholes equation
and binomial lattices
These are appropriate for real options which
are very similar to financial options
Methods that account for multiple and
varied sources of uncertainty, such as
decision tree analysis and Monte Carlo
simulation
Appropriate for "real world" problems with
uncertainties that don't follow a well–defined
mathematical processes

6. 6
Who Really Cares about “Real Options?”
IT investment analyst
Heuristic investment decision makers
Decisions that must be made in the
presence of risk and uncertainty
Investment decision involving multiple risks
with numerous ways to configure the
investment
Cascading risks and their decisions
The CIO should (must) care about “Real Options”

7. 7
An Acquisition Example
IT has the option to spend money, K to acquire an IT
asset
At any point in time, t, during an interval [0,T], K is known with
certainty
Future changes in K, are uncertain
After the asset is acquired, cash flow, C, is received representing
differential benefits from the acquisition of the IT asset
Since the cost and the benefits are uncertain it might be
better to wait before investing in the IT asset
The costs may decrease over time (as is the case in many IT
investments)
The benefits may decrease over time as well in the absence of
the IT investment
Both the cost and the value are uncertain
What is a CIO to do?

8. 8
An IT Development Example
For an IT development project
The results of the development efforts is not acquired
immediately
The development project has an uncertain duration,, in which
the IT department keeps investing at a rate that is less than or
equal to a maximum investment rate, Im.
Only until the project is completed and the remaining cost, K, is
zero, do the customer of the IT development project receive the
value from the underlying asset, V
Both the cost and the value are uncertain
What is a CIO to do?

9. 9
What Does L&F Provide for RO?
Modern Portfolio Management
We’re a provider of these services
UMT provides the means of assessing
investment decisions – “economic frontier”
Monte Carlo Simulation (MCS)
Is the basis of probabilistic risk analysis –
something all our project management
consultants use with their schedules