Managing Risks of Supply-Chain Disruptions: Dual ... - CiteSeerX

zero).Traditional NPV works only for certain future and assumes that the project will meet a given set ofcash flows. As it doesn’t take into account uncertainty, all the more so it doesn’t integrateflexibility! Traditional NPV is therefore a static valuation method that doesn’t include the value offlexibility and undervalues investment made under uncertainty.In order to value real options, new techniques are required. Most of them rely on financial optionpricing.4.2.2 Option Pricing TheoryThe basic idea enabling the pricing of options is to create a portfolio composed of N shares of theunderlying asset and B bonds that will replicate the payout of the option. Since the option and thereplicating portfolio have the same payoffs, they must sell at the same price to prevent arbitrageprofits.Let’s assume that the price of the underlying stock S is currently $100 and will move either up to$140 (ie with a multiplicative factor u=1.4) with probability q or down to $80 (with amultiplicative factor d=0.8) with probability (1-q). Assuming an exercise price of 110, the payoutsof the call option contingent on S will be $30 in the up state and $0 in the low state. (Table 4.2)Table 4.2: Binomial Representation of a Call Option and its UnderlyingUnderlying StockCall Optionq+S =140q+C =Max (S + −110,0)= 30S=100C1-q−S =801-q−C =Max (S − −110,0)= 0The replicating portfolio is composed of N shares of the underlying risky stock and B dollars of therisk-free bond whose present value is 1$ per pond. At the end the replicating portfolio has thefollowing payouts:38