The Use of Real Options in SC and Procurement Risk: Part 1

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Well, its been a few weeks since my last post but have been busy with client work which, on the bright side, has given me lots to write about in the coming days. The first topic on the agenda is what are normally called “Real Options”. This technique is probably the least understood and yet most powerful risk management technique available to SCM professionals today. I will start my discussion on  Real Options (“RO”s from now on) but describing (a) what they are (b) how they are priced and (c) how they can be applied to solve real world SC and procurement risk.*

Let’s start first with what exactly a RO is, since my experience is that most SC and Procurement professionals have not come across these mechanisms in their career, nor are ROs taught in SCM classes at the undergrad or MBA level. However, ROs are not that hard to grasp conceptually and, in fact, once they are understood, I have yet to see a top tier SCM pro who does not immediately see potential applications in their work, regardless of industry.

So what is an RO? A RO is really an option (defined as the right to do “something”) relative to a real (as distinct from a “financial”) thing. In other words, if you think of a financial option as, for example, the right to buy (a “call”) or sell (a “put) a share of stock, an RO is simply that same right but applied, say, to an airplane or an hour of manufacturing time or a rail car’s worth of steel. That’s pretty much it at the basic level.

In order to create an RO, the buyer and seller of the RO agree typically agree on three things: The object of the option (airplane, manufacturing capacity, etc) which is often called the “underlier”. The time frame of the option (days, weeks, years, etc) and the price of the option (which can me static or variable). For example, I may want to lock down the right to buy a $100M airplane from Boeing for the next five years. Boeing agrees to sell me that right at a cost of $1M per plane for the duration of the 5 year period. The underlier, then is the plane, the cost (in this case fixed over the five years) is 1% of aircraft cost and the time frame is five years.

Things, of course, can get more complicated than that but let’s leave that aside for a moment. For now, the key point is that an RO is a kind of mid-way point between having and not-having, buying and not-buying — sort of the “Schrodinger’s cat” (http://en.wikipedia.org/wiki/Schrödinger’s_cat) of the contracting world.

So a simple concept yes but, as one can quickly imagine, setting a price for such an RO is not the easiest of things and that’s what we will cover in Part 2.

*My thanks to Prof Alex Triantis of the Robert H. Smith School of Business at the University of Maryland in the US for his guidance in helping to understand and apply RO’s in SCM applications.

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