Real options
Ryan O. Murphy’s Homepage

    Consider an example of a professor considering investing time and effort toward the intellectual and professional development of a graduate student. The likelihood of the graduate student's succeeding (graduating, seeing projects through to publication, developing into an autonomous researcher) is unknown but the uncertainty about her prospects is reduced over time as the student matriculates. Nonetheless, the professor must decide up front if and how much time and effort to invest toward the student's development. The professor can revisit this arrangement every semester, based on new information related to the likelihood of the student's eventual success. Students with an estimated high probability of success warrant the investment of time and effort, whereas students with an inauspicious future would warrant removal from candidacy.

    What we develop here is a problem that retains the central conflict these examples have at their core and is tractable to modeling. Namely, a decision maker is faced with the option of trading a certain amount of real, current value, for a risky option with potentially greater future value, within the context of a dynamic environment, which provides information and updated options as time passes. Dynamic decision problems like this are referred to as Real Options and are widely encountered in venture capital investing, mineral and oil exploration, and research and development contexts, law, corporate finance, and biology (foraging or mate selection) as a few examples.

Click here to play a real options decisions game.