Practical Valuation of Options on Durable Goods

Abstract

Option theory designed to value puts and calls on traded financial instruments has been profitably extended in many directions, one of which is to “real options.” Real options refer to choices that can become economically valuable in the future and whose existence can be valued in the present using (one hopes) more or less standard option pricing techniques. Most examples involve investment projects and similar choices at the firm level. In this article, Afik looks at some real options that are offered to individuals, that is, car buyers. A customer buys a new car from a dealer, who commits to buy it back as a used car in the future at a pre-specified price. The exercise price may vary according to how old the car is when the customer exercises the option. The option’s moneyness is a function of prices in the used-car market. A second related optional contract allows the customer to swap the old car for a new one of the same type at a fixed price difference. The swap contract (actually an option to exchange one asset for another) is influenced by prices for both used and new cars on the exercise date. The author presents valuation models and a simulation to illustrate valuation of these consumer real options.

TOPICS: Options, simulations, derivatives