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---------------------- Forwarded by Vince J Kaminski/HOU/ECT on 03/31/2000
04:04 PM --------------------------- Jim Dyer <Jim.Dyer@bus.utexas.edu< on 03/31/2000 03:11:37 PM To: "'Vince.J.Kaminski@enron.com'" <Vince.J.Kaminski@enron.com< cc: Subject: Presentation at UT Vince, I appreciate your response to my request for you to speak to my class on real options. I thought you might enjoy the following exchange of emails that occurred yesterday. Perhaps some of these issues could be addressed in your talk. Jim -----Original Message----- From: Sheridan Titman Sent: Friday, March 31, 2000 9:11 AM To: Jim Dyer Subject: RE: Real Options Course Feedback Jim: Your student has raised some difficult questions. I would recommend Ehud, but I thought that the finance people have the answers in cases with complete markets and that we rely on the decision science people for cases with incomplete markets. If it would help, I can come in at 6pm after my class in a couple of weeks. Sheridan Sheridan Titman Department of Finance College of Business Administration University of Texas Austin, Texas 78712-1179 512-232-2787 (phone) 512-471-5073 (fax) titman@mail.utexas.edu -----Original Message----- From: Jim Dyer Sent: Thursday, March 30, 2000 4:37 PM To: Sheridan Titman Subject: RE: Real Options Course Feedback Sheridan, Which of your classes do you want to miss? Just kidding. Actually you probably told me that before. Can you suggest someone else who would be a good choice to discuss the use of option theory in the context of incomplete markets, and to address some of the types of questions raised in the note from the student? Jim -----Original Message----- From: Sheridan Titman Sent: Thursday, March 30, 2000 5:58 PM To: Jim Dyer Subject: RE: Real Options Course Feedback Jim: I teach at the same time as you do. Sheridan Sheridan Titman Department of Finance College of Business Administration University of Texas Austin, Texas 78712-1179 512-232-2787 (phone) 512-471-5073 (fax) titman@mail.utexas.edu -----Original Message----- From: Jim Dyer Sent: Thursday, March 30, 2000 11:32 AM To: Sheridan Titman Subject: FW: Real Options Course Feedback Sheridan, See the comments below. I don't mean to put you on the spot, and have not announced anything in class, but I am hoping that you could visit my class for about an hour one Thursday afternoon to discuss your views regarding applications of option pricing concepts to "real options". As a reminder, I've attached a course outline. Chris Kenyon from Schlumberger is speaking on April 13, and Vince Kaminski has tentatively agreed to speak on April 20. I am going to be out of town on April 27, so that leaves either next Thursday (April 6) or May 4. Would either of those times work for you? I'm not thinking of any preparation, but more of an informal discussion of the "philosophical issues" related to real options work. Jim -----Original Message----- From: Jim Dyer Sent: Thursday, March 30, 2000 1:24 PM To: 'jclevenger@optionii.bus.utexas.edu' Subject: RE: Real Options Course Feedback Josh, Some very thoughtful observations. As you know, I had invited one finance professor to our class on Arundel, but he was out of town. I do plan to invite Sheridan Titman to discuss the issue of using the option models in situations where there is no underlying security that is traded. I do think it is important to face that issue, which is actually covered at a theoretical level in our last couple of readings. The issue of volatility is also an excellent issue for further discussion, as you suggest. So far, we've been looking at cases where volatility is "given". The problem of finding an "objective" measure of volatility for a project reminds me of the problem of finding the correct risk adjusted discount rate, which is not surprising since the concepts are almost two sides of the same plate. One approach, of course, is to do some modeling using traditional decision analysis tools, including subjective probabilities, but the finance people who write options articles don't like to think about such ideas. I'll try to address these issues in more detail as the semester continues. I think it was important to surface some of these points early, and to come back to them after we have seen how to apply the methods in a naive sort of way. Thanks for the feedback and comments. Jim -----Original Message----- From: jclevenger@optionii.bus.utexas.edu [mailto:jclevenger@optionii.bus.utexas.edu] Sent: Thursday, March 30, 2000 8:42 AM To: Jim.Dyer@bus.utexas.edu Cc: josh-clevenger@reliantenergy.com Subject: Real Options Course Feedback After overcoming the initial (I hope) overload of materials and tools presented thus far in the semester, it appears to me that you are achieving the objective of making us comfortable with optionality valuation as applied to a variety of problems which are outside the borders defined by a liquid market of traded financial elements. As a constructive feedback, you have been forthright with us in marking off areas of this subject which are still controversial. I also realize that rightly so, real-world application of this type of analysis without a robust understanding of finance may degenerate into a succession of assumptions that result in a "house of cards" effect. My opinion at this point is that two issues are of potentially "make-or-brake" importance if I am to persuade my superiors to accept these methods for valuations outside the realm of projects whose value is primarily driven by the value of commodities backed by financial instruments. These issues are easy to guess: 1) Discounting and Risk Free rates: I do not sense that anyone in the class has put forth convincing arguments as to the proper application of time value questions in the absence of liquidity. Is there someone within the finance department that can present a firmer position on this question? 2) Volatility: I found Winston's examples on this metric succinct. I would recommend that in future years you dedicate some hours of class time to this subject. My criticism again relates to messy problems. I anticipate arguments against real option applications based on the dispute of volatility measures. If I were a conservative financial manager, I would argue that: *** Two-a: implied volatility derived from an industry specific slice of equity options is a shotgun approach -- the projects being valued are of a tranche which may in fact have a significantly different outcome variance than the weighted average measured by the equities utilized. Oil, gas and electricty are good examples the major players are competing on many different levels of the value chain. Smaller companies do exist which are dedicated to one strata, but what about projects that want to exploit opportunies across strata in a vertically integrated company? *** Two-b: based on the following skepticism - if a real option value is being proposed for a new business venture (some new unexploited opportunity,) there is some paradox embedded in the increased value based on high volatility in new ventures and the high risk of failure. This skepticism is likely to be less acute in high-tech sectors where the huge upside of new ventures is paraded before us daily by NASDQ touts. It is a much harder sell to "mature" industries. Of particular interest in the power industry are investments centered around opportunities arising from restructuring of electricity and natural gas sectors as regulation is removed. A large proportion of the risk is embedded in ongoing changes of public policy on an international basis. As an intentionally screwed-up example, can anyone other than a financial genius correctly asses volatility for U.S. companies investing in seed projects in Mexico based on speculation of the inevitable dismantling of the national utility (CFE) and PEMEX? James S. Dyer Fondren Centennial Chair in Business Department of Management Science and Information Systems CBA 5.202 The University of Texas at Austin Austin, Texas 78712-1175 Email: j.dyer@bus.utexas.edu Telephone: 512-471-5278 Fax: 512-471-0587
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