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Enron Mail |
Erin,
A book by Martha Amram and Nalin Kulatilaka is an excellent non-technical introduction to real options and it contains all the most important references to more advanced books and papers. The book has an endorsement by Jeff Skilling on the cover page. The Research Group offered several one-day seminars on real options and applications to the energy industry. We still have a few binders with the presentation materials available if you are interested. We plan to repeat the seminar sometimes in the fall. The first part of the seminar (about 4 hours in the morning) covers general concept of real options and their applicability to the energy business. The second, more technical afternoon session, covers stochastic processes used to model price uncertainty in the energy markets and specific case studies (valuation of natural gas storage facilities and of peaking gas-fired power plants). The real options approach has been developed specifically to address the problem of making investment decisions under uncertainty. Nobody in this field claims that this is a perfect tool, but it represents a significant progress compared to other techniques developed earlier. Discounted cash flow analysis that tries to incorporate uncertainty through analysis of several, in most cases, arbitrary scenarios (most likely, optimistic, pessimistic). These scenarios don't identify explicitly the risk drivers and don't specify the future proactive management decisions. The real, option approach is very powerful because it allows to (1) capture uncertainty in an explicit way and (2) to design investment projects that allow to exploit future positive developments and reduce future exposures to downside risk. This approach allows also create a link between investment decisions and future operational decisions. Forward-looking investment decisions create options that are exercised in the future through active management of a project. The real options technology relies heavily on advanced statistical tools to come up with the representation of future possible states of the world. The real challenge is to use these tools in a sensible way. I have seen in my career (almost 30 years of applying mathematical tools to business and economic problems) many quants armed with powerful computers who reminded me of monkeys armed with hammers. The challenge is not to run mechanically thousands of simulations based on arbitrary assumptions but to translate in a creative way the insights of people who understand specific businesses into parsimonious quantitative models. It is especially critical to stress-test the assumptions of any model and to ask the question if the outcome of a model depends critically on any set of assumptions. If this is the case one should use common sense to examine the underlying assumptions. I remember that in the early eighties quite a few models simulated the dynamics of oil prices, but all the stochastic scenarios represented fluctuations around a very optimistic upward trend. One would have been better off stepping back and asking a simple question what Economics 101 teaches about cartels and the dynamics of supply and demand. Enron North America Corp. From: Erin Rice @ ENRON 06/27/2000 03:52 PM To: Vince J Kaminski/HOU/ECT@ECT cc: Subject: Pre-submitted question on eSpeak Good news! There is already a question waiting for your July 12 eSpeak session. I have pasted it below, although you don't have to respond until the actual event. Don't forget to send a bulleted list of discussion topics if you would still like us to advertise the event on the elevator screens. Thanks. - er submitted by breineck I was doing some reading about the application of real options in the evaluation of non-financial assets. Would you recommend any texts or articles for a more in-depth study of this area? Is quantification of risk or uncertainty the major challenge in using this concept? Can statistical tools be used with this to do a sort of sensitivity analysis?
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