Page 238 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 14: Real Options and Cross-border Investments

Closed form, Black-Scholes-like solutions are sometimes employed. These are applicable Notes
only for European styled options or perpetual American options.

The most commonly employed methods are binomial lattices. These are more widely
used given that most real options are American styled. Additionally, and particularly,
lattice-based models allow for flexibility as to exercise, where the relevant rules may be
encoded at each node. Note that lattices cannot readily handle high-dimensional problems.
Specialised Monte Carlo Methods have also been developed and are increasingly, and
especially, applied to high dimensional problems. Note that for American styled real
options, this application is somewhat more complex; although recent research combines
a least squares approach with simulation, allowing for the valuation of real options which
are both multidimensional and American styled.

When the Real Option can be modelled using a partial differential equation, then Finite
difference methods for option pricing are sometimes applied. Although many of the early
ROV articles discussed this method, its use is relatively uncommon today—particularly
amongst practitioners—due to the required mathematical sophistication; these too cannot
readily be used for high dimensional problems.

Notes Various other methods, aimed mainly at practitioners, have been developed for
real option valuation. These typically use cash-flow scenarios for the projection of the
future pay-off distribution, and are not based on restricting assumptions similar to those
that underlie the closed form (or even numeric) solutions discussed. The most recent

additions include the Datar – Mathews method and the fuzzy pay-off method.

Self Assessment

Fill in the blanks:
5. The …………………… framework (implicitly) assumes that management is “passive”
with regard to their Capital Investment once committed.

6. …………………… assumes that management is “active” and can “continuously” respond
to market changes.
7. …………………… price corresponds to any (non-recoverable) investment outlays, typically
the prospective costs of the project.
8. …………………… term is the time during which management may decide to act, or not
act, corresponds to the life of the option.

14.3 Foreign Direct Investments

Foreign Direct Investment (FDI) is investment made by a transnational corporation to increase
its international business. When firms become multinational, they undertake FDI. It generally
involves the establishment of new production facilities in foreign countries to earn extra returns.
The foreign investment decision results from a complex interaction of factors that differ in many
ways from that governing the domestic investment decision. Foreign investment is generally
motivated by a complex set of strategic, behavioural and economic and financial considerations.

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