Uncertainties associated with the project itself. How will its actual costs compare to estimates? How will performance compare to forecasts? These are the project risks.

Uncertainties in the value of the product when it is brought to market. These are the market risks.

Options analysis deals with the issue of constantly varying discount rates through a process whose net effect is to adjust the project outcomes, so that the risk-free rate can be applied. This process is known as "risk-neutral" valuation. This process requires detailed statistical information on the price and volatility of an asset that is closely related to the project or product at hand.

Practical Hybrid Real Options Evaluation of Risky Projects

A practical approach to valuing real options combines options methods for the market risks, and decision analysis for the project risks. A main advantage of the hybrid approach is: -

It effectively combines the best of the decision analysis and the options analysis into a practical means of accurate valuation of projects.

It permits a consistent choice of discount rate for the valuation, the risk-free rate. This is possible because: -

• the project risks can be diversified, and therefore, require no compensation for risk, and the market risks are transformed by the options analysis, so that no further compensation for risk is required in the discount rate.

The hybrid approach to the evaluation of real options divides the valuation process into a technical and a financial part, associated with the project and market risks. Technical and financial experts can handle each of these independently, separately applying their knowledge to the technical and financial aspects of the evaluation.

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* Contributed by -
Jyoti Singh,
PGDBM 2006,
IMT, Ghaziabad.