The Nature of Option Interactions and the Valuation of Investments with Multiple Real Options

Abstract

This paper deals with the nature of option interactions and the valuation of capital budgeting projects possessing flexibility the form of multiple real options. It identifies situations where option interactions can be small or large, negative or positive. Interactions generally depend on the type, separation, degree of being in the money, and the order ofthe options involved. The paper illustrates, through a generic example, the importance of properly accounting for interactions among the options to defer, abandon, contract or expand in? vestment, and switch use. It is shown that the incremental value of an additional option, the presence of other options, is generally less than its value isolation, and declines as more options are present. Therefore, valuation errors from ignoring a particular option may be small. However, configurations of real options exhibiting precisely the opposite behavior are identified. Comparative statics results confirm that the value of flexibility, despite interactions, manifests familiar option properties.