nm0966: for foreign students [0.7] and also to see what idiosyncracies 
lecturers have [0.8] so [0.3] right so [laughter] [0.7] let's go [0.7] er next 
week [0.2] last week [0.9] just to confirm [2.2] no lecture [0.6] on the last 
day of term [0.4] so [0.2] this [0.2] will not take place next week [1.9] ah [3.
5] er i'm going to run [1.1] open access [0.3] for the computer workshops next 
week [0.2] it's the turn of the portfolio management groups [0.8] er but as [0.
2] there are a lot of common [0.4] students between the two [0.5] so if you 
want to come in and [0.2] go through [0.7] parts on your projects and anything 
else on the capital raising [0.3] open access [0.8] next week [0.6] at any time 
[0.4] it would be helpful if the portfolio management people keep to their 
group schedule [0.8] and then anybody that [0.2] sort of wants to drop in or 
drop out [0.5] we can er [0.2] pick up [0.2] questions and other things on 
projects [0.4] as we go through [4.0] er [0.3] i've dropped leasing from the 
syllabus [0.6] 'cause i was away last week and just won't have time to pick it 
up [0.4] so that's [0.2] out of the syllabus [1.9] and [0.2] er [1.4] i've 
included [laughter] [0.2] the more complicated [0.2] convertible bond file [0.
9] on [2.1] 
the modelling techniques [0.6] on the simulation it's called C-B Monty Put Call 
[0.4] it's in the Q drive [0.4] this reconciles with [0.2] namex's file [0.8] 
so if you want to use this in the project and [0.3] have a put or a call or 
whatever you want [0.2] you can [0.3] reconcile it back to namex's model [0.4] 
and use that as well [0.6] you should be able to [0.6] follow it it's er [0.4] 
instead of having one bullet option it's got a series of options [0.5] and tr-, 
goes through ten years like the er [0.6] ten periods [0.8] like the binomial 
model [0.7] so that's on [0.7] the Q drive [0.8] if you want to use it [24.8] 
okay there's a handout [0.7] on this [1.7] just over here [0.5] if you want to 
pick it up later [8.4] i'm er [0.5] i'm going to go through [1.3] the theory [0.
4] of real options [1.1] and then [0.2] i'm going to show you [1.5] how they 
can be [1.2] used [0.8] to [0.6] raise some money [1.0] particularly on 
property assets [3.8] real options er [0.7] are a term which [0.6] was coined 
[1.2] ten fifteen years ago [0.5] when people began to realize that [0.7] net 
present value isn't the only thing [0.5] that you should look at [0.4] in 
valuing assets [0.7] that [0.2] a number of [0.8] assets [0.5] in 
companies [0.4] have a great deal of option value [1.5] and so the [0.7] option 
theory [0.4] that you've been looking at [0.8] can be also applied [0.7] to [0.
3] real assets instead of just financial assets [1.1] and that in raising money 
[0.2] companies particularly have [0.6] a lot more to offer [0.5] from an 
option pricing perspective [0.5] than they first thought [1.1] the [1.6] the 
idea on on real options is that management is just not [0.6] a passive [0.7] 
participant [0.6] that management can take an active role [0.8] in er [0.8] in 
making and revising decisions [1.1] that can lead [0.4] er on from [0.6] 
unexpected market developments such as for example the price of oil [0.7] has 
gone up from er ten pounds a barrel to in excess of thirty pounds a barrel [1.
0] over the last year [0.8] so if you were an oil [1.4] producer this time last 
year [0.9] you would be taking a very different view [0.3] on the market for 
oil [0.5] so the increase in [0.3] oil prices has uncovered [0.4] a stream of 
options [0.3] which make [0.8] the er the oil [0.7] producers a lot more 
valuable [0.5] and now you can bring oil fields back on stream that [0.2] were 
not necessarily economic [0.8] er so 
this is the the kind of idea [0.4] that when we're looking at a project [0.4] 
we're just not looking at a static cash flow we're actually looking at a cash 
flow that can be subject to a lot of optionality in it [1.2] so [0.4] real 
options [0.8] assume that management is not an inert force [0.2] that 
management actually understands what it's doing [0.7] and then it that it can 
act [0.2] and react [0.3] very quickly [0.5] to changes in the economic 
environment [0.9] many of the high tech companies are valued on real options [0.
6] in that [0.6] there's so much happening [0.3] in [1.2] tech at the moment [0.
7] that [0.2] er even though they're not earning current cash flows that the 
possibility of being able [0.2] to be on the ground [0.2] and earn those sort 
of cash flows in the future [0.6] represents enormous opportunities so many of 
them are valued using real options [2.4] the [0.6] the flexibility [1.1] comes 
down [0.7] to being able to [0.2] improve upside potential [1.6] firstly [0.8] 
and then it's also assumed that management will [0.9] have some damage 
limitation on the downside losses [1.0] so that it can move extremely 
quickly [0.5] and is not a passive entity [0.8] so we've got [0.9] another item 
here we've got [0.3] a passive net present value [0.7] of expected cash flows 
which is what you've done in the workshop [1.1] over the last couple of days [0.
5] we've done a very passive [0.5] look at it [0.6] nothing has changed [1.2] 
we've got to add to it [1.0] the value of options [0.4] from active management 
[0.5] which i'm going to do in the first week of next term [0.7] that we're 
going to make [0.3] the price process stochastic [0.5] and we're going to see 
[0.3] on that [0.4] fairly simple little project that you did [0.8] what other 
[0.6] areas of value [0.4] that we can find out [0.6] of that project [0.5] and 
just to compare what its passive [0.6] value is [0.4] with what its active 
value is [3.0] so these are the types of [0.7] of real options [1.0] which are 
available [1.4] you have an option to defer a project [1.2] you don't have to 
keep on [0.8] going on with a loss making project [1.1] it means you have to 
mothball it [0.3] if you're going to defer it so there are some [1.0] there are 
some cost to putting it in mothballs [0.5] and just [0.2] leaving it there [1.
5] there's an option 
for staged investments [1.3] that it's possible [1.4] when you go through a 
product life cycle [0.5] that [0.3] other [0.9] options become available as you 
are going through [0.6] this life cycle [0.4] and so you can look at it in a 
kind of a staging process that as management learns [1.1] what is going on it 
can then [0.3] acquire that new [0.3] technology and go into another technology 
[0.7] my old favourite B-T [0.3] is just starting to do that now its share 
price has just recovered as it's starting to [0.7] find out that there are 
other things in the mobile market and it's making a move into the mobile market 
and so it's [0.3] using [0.3] its own platform to stage investments and to er 
[0.2] to move through and the share price has [0.4] has recognized that [0.6] 
so it's starting to move up [2.1] you can change scale [0.9] on a project [1.7] 
with the [0.8] increase in oil values [0.2] oil prices rather from [0.6] ten [0.
4] dollars a barrel to thirty dollars a barrel [0.5] you can most certainly 
bring on [0.2] an huge change in scale [0.8] of the projects and i would 
imagine 
that [0.6] when OPEC gets its act together it will most certainly be doing this 
[sigh] that when they finish squabbling [0.7] that what we will find is they're 
a huge change of scale [0.6] from OPEC and it will then once again as it 
normally does flood the market [0.7] and the price will [0.5] come down [0.6] 
but [0.4] this is now [0.6] er with that [0.8] threefold increase [0.9] a huge 
ability to change the scale of production [1.3] you can of course [0.5] abandon 
[1.4] but if you make [0.5] the wrong decision [0.9] there is nothing worse 
than throwing good money [0.2] after bad [0.8] and making the wrong decision [0.
5] so [0.5] fundamentally [0.4] quit [1.1] so there's always an option to 
abandon [1.3] er there are options to switch [0.2] er the technology [0.8] 
might be appropriate [0.7] for [0.2] another area [1.0] that you could become 
involved in [0.6] or alternatively you could switch [0.6] er from gold [0.3] if 
[0.3] to silver or lead zinc [0.6] if you're in a field that has gold and 
silver lead zinc the gold price goes down you can switch to a product [0.6] 
which [0.3] er potentially is going to give you more revenues [1.5] er [0.2] 
options to grow well that's fairly [0.3] self-explanatory 
and this is all the Internet [0.6] all the Internet companies come in here 
[laugh] [0.4] that er [0.2] people are seeing enormous growth options [0.7] 
potentially in the Internet companies [1.0] er and importantly [0.8] er [0.7] 
these are not [0.7] mutually exclusive [1.4] the there are interacting options 
[0.8] within all of this framework so you can potentially have options on 
options [1.0] which tend to be [0.3] extremely explosive [0.3] in terms of 
valuing things [1.0] but [0.3] but what this [0.2] all assumes is that 
management is good [1.6] and [0.5] i think you'll probably find that over [1.0] 
the next few years that a lot of inept management will be flushed out [0.7] of 
the system [0.5] and that [0.2] the er the high fliers [0.2] will [1.0] have 
gone too near the sun and will have their wings melted [0.8] and will [0.6] 
plummet to earth [0.2] in a very big way [0.6] so this assumes that there is 
the management to be able to recognize [0.6] the optionality [0.9] of these 
opportunities [7.5] just to go through those in a little bit more detail [1.6] 
options to defer [0.9] so management could hold a lease [0.6] or an 
option to buy valuable land [0.3] or resources [0.7] so it can wait for a 
number of years to see if output prices justify the construction [0.7] of a 
building [0.6] or a plant [0.2] or a project development [1.0] important in 
natural resources [1.3] extraction [0.7] real estate [0.3] farming [0.7] paper 
[1.2] 
those sort of industries that require a long lead and lag time [6.8] have a 
series of outlays that create the option to abandon an enterprise in mid-stream 
[0.7] if no er [0.2] new information's er [2.2] if sorry if new information is 
unfavourable [0.4] and each stage can be valued [0.4] as a compound option if 
we're looking at stage development [0.6] that's in R and D [0.6] especially 
pharmaceuticals [0.8] long development capital-intensive projects [0.7] energy 
[0.5] start-up [3.1] options do alter scale [1.4] if market conditions are more 
favourable [0.5] the firm can expand [0.2] or accelerate resources [0.4] if 
they're less favourable [0.5] it can reduce the scale [0.5] and potentially 
mothball [0.6] the project [0.8] natural resources again [0.4] mines this is 
particularly important in mining [0.5] because of the scale of operations [0.8] 
fashion as 
well consumer goods [0.2] and commercial real estate [2.3] i've covered 
abandonment [0.4] and switching [2.0] and growth [0.6] right [2.9] now [0.4] 
the comparison [0.5] between [0.5] stock [0.5] and real options [0.6] so these 
are the [0.7] the variables in the [1.4] financial option [1.5] and these are 
the variables [0.5] in the real option [0.4] so there's slightly different 
nomenclature [0.8] so while we've got the current value of the stock [0.8] as 
one variable [0.5] what we've got on the real options is the gross present 
value of expected cash flows [0.7] that we're looking at valuing [1.0] we've 
got [0.6] exercise price [0.7] in the financial option [0.6] and we've got 
investment cost [0.8] in the real option [1.4] we've got [0.7] time to expiry 
[0.3] in the financial one [0.7] and we've got time until the opportunity [0.4] 
the investment opportunity [0.4] disappears [0.7] in the real option [1.2] 
we've got [0.8] stock value uncertainty [0.8] measured by the standard 
deviation of returns [0.6] and we've got project uncertainty which can be 
measured [0.5] within the same [0.3] sort of standard deviation parameters [0.
8] and we've got the riskless [0.6] interest rate [1.1] on this [1.2] 
financial options no we can use that [0.5] because we can form the hedge 
portfolio [0.8] and by hedging the portfolio [0.2] we can assume that the asset 
grows [0.6] at the riskless interest rate [0.3] it's very difficult to form a 
hedge portfolio [laugh] [0.3] on a [0.2] real option [0.6] so we have to manage 
that [1.1] and adjust [1.1] the interest rate and i'll come to this in an 
example fairly shortly [0.5] by what's known as the market price of risk [1.4] 
to bring us back into a risk u-, [0.2] risk neutral universe [0.9] to do the 
pricing [0.7] so th-, [0.4] all of the terminology [0.3] is analogous [0.9] in 
terms of [0.7] valuing real option opportunities [1.4] and there are [0.7] in 
raising money [0.2] i think that er [1.1] companies [1.3] do not really realize 
the value of the real options [laugh] [0.4] which might be available [0.6] and 
that the stock market [0.8] is [0.6] only just becoming to realize [0.6] that 
apart from the technology sector there are huge values in real options [0.5] 
and as that goes through as the [0.2] as the market realizes that then the 
share price will alter [laugh] [0.2] and then the companies will be able to 
raise more capital because they've 
been able to convince the market that they've got some [1.0] significant option 
value [0.8] in [1.3] their [0.3] their asset stream and in their opportunity 
stream [0.4] at the moment in this country [0.7] er property companies are 
selling well below net asset value [1.5] because people are simply not 
realizing the optionality [0.4] which is available [0.4] through the cash flows 
[4.2] er the options [0.7] are normally path dependent [3.5] their value 
depends on some action taken in the past [1.1] that impacts on future values [2.
3] so we can use [1.3] the three models that you've been seeing [0.4] through 
the term [0.9] er Black Scholes [0.4] er which is the least appropriate [1.3] 
er because it it is difficult to adjust [0.2] that for path dependency [0.9] er 
the two [0.2] the better [0.3] opportunities are the binomial [0.8] or [0.3] 
simulation models [0.8] the binomial you can alter [0.7] at a node [0.7] what 
might happen [0.8] to [0.7] an option value [0.6] you have to be careful in [0.
2] the binomial [1.3] because [0.2] if you alter [0.9] er the the volatility 
patterns [0.5] the binomial will not recombine [1.4] so instead of the tree 
going nicely up [0.5] and coming back to where it first started [1.0] 
and then [0.2] doing [0.3] a similar [0.2] thing as it goes through the tree [0.
6] if you have a [0.4] a tree that doesn't combine [0.9] then you start to have 
[0.5] two-to-the-N nodes [0.8] and when you get to something like two-to-the-
eighth or two-to-the-tenth it's er [0.2] it's something like a thousand-and-
twenty-four nodes at the end [1.1] which means that the tree becomes completely 
unmanageable [0.7] if you start changing [0.4] parameters [0.5] and volatility 
patterns and other things at each node [0.6] so the only reason that trees work 
[0.8] or work nicely unless you do [0.2] some very clever pruning [laugh] [0.3] 
of the trees is that they recombine [1.0] and so [0.3] a ten year tree just has 
[0.6] ten nodes on it [0.6] so the one we're going to be doing is simulation 
which is real easy [0.9] to do because you can incorporate all sorts of path 
dependency [1.2] into simulation models [4.1] so i'm [3.5] going to go through 
[3.5] some stuff [4.4] on options [0.6] on real options [1.4] that i've been [0.
4] working on [0.3] with the Land Management department [1.0] on [0.9] trying 
to [0.4] peel out some [0.2] value [0.9] in the company's real estate assets [1.
2] so that it can [0.5] either [1.1] spin those [0.4] 
real estate options out [0.9] or it can convince the market [0.5] that it's got 
more value in it and by convincing the market it can then [0.6] hopefully get a 
better share price [1.0] and then [2.0] be able to do some sort of [0.3] rights 
issue [0.3] or other placement [0.6] in terms of [0.2] giving itself some added 
value [1.4] so this is [3.0] this is a problem with [0.7] property [0.4] a 
company's [0.7] always [0.4] have to have somewhere to live [1.0] they've 
always got [0.5] a lot of property [0.4] on their balance sheets [1.6] property 
is one of the most [0.2] underutilized assets [0.8] that a company has [0.6] 
historically [0.5] companies have only used property [0.7] as [0.8] a 
mortgageable asset [1.2] which we did [0.2] [laugh] [0.4] in the workshop that 
we've just done [0.7] that we mortgage seventy per cent at a fixed rate [1.6] 
er [0.6] very few companies use their asset base [0.4] sufficiently to raise 
capital [1.0] er mortgages can be [0.2] quite expensive [0.7] because of the 
valuation fees that are involved [0.7] er [0.2] because of the stamp duty [0.3] 
which is involved as well [0.7] and so there are other [0.3] better ways [0.2] 
er [0.2] for a company to use its property portfolio [0.8] than just [1.4] 
raising mortgage funds against it [1.5] er [0.2] there are problems with [0.3] 
companies property portfolios [0.3] firstly is the large size of each 
individual transaction [1.4] er [0.2] shares are nice [0.6] you can [0.2] take 
shares down into nice little bite size numbers [laughter] and [0.4] do a 
thousand [0.2] or a hundred or whatever it might be [0.8] very difficult [0.5] 
on property because it's lumpy [1.5] and it's [0.4] hard to manage if you have 
to find a buyer for just a big lump of property [0.5] it means that there are 
very few buyers around [0.8] that can swallow up the property [1.3] always [1.
2] government [1.3] being government [1.1] sees property as a wonderful source 
of revenue [1.2] and so to move property [1.1] you have to pay a huge amount of 
stamp duty [1.2] just about anywhere [1.2] and so this is [0.5] [laugh] except 
in the United States which didn't like stamp duties anyway [0.4] [laughter] but 
er this is one major source of revenue [0.5] in a lot of [0.2] countries [0.3] 
is that if you do sell it you've 
got to pay huge amount of transaction costs to do it [0.5] so the transaction 
costs [0.6] which you've discovered [0.5] in the portfolio management just 
between the offer and bid [1.3] are [0.4] are exacerbated [0.5] because in to 
move property in this market [0.7] is six per cent front end transaction cost 
[0.7] by the time you fold in all of the stamp duties [0.4] so not only have 
you got the difference between the offer and the bid but you got to pay another 
six per cent [0.7] to the government [1.2] to move property [2.7] it's also got 
a lot of [0.2] valuation fees attached to it [0.7] er [0.5] the the property 
market [0.6] for companies trying to raise money [0.4] er [0.5] is very [0.3] 
very hard to get a fix on just [0.3] what your property's worth [1.2] and 
valuers [0.5] smooth the series [1.3] so what you've got is [0.7] that valuers 
instead of doing their job properly [0.3] look backwards and say well what sort 
of property was this when it was valued last time [0.6] and so the whole of the 
[0.2] the valuation parameter tends to be autoregressive [0.7] and you find 
that it's an extremely smooth valuation 
parameter and you actually don't ever get what the market is you can only get 
the market when you do a deal [0.6] and there's no screen based property 
trading because it's not an homogenous asset [0.4] so you're never quite sure 
what you've got [2.1] 
which is brings to [0.5] incomplete market information that nobody really knows 
[0.4] what their property's worth until they put it on [0.9] the market [1.2] 
and every property asset is complex and unique [0.9] so while you may have a 
row of houses [0.6] that comes on to the market that [0.2] all looked the same 
when they started [0.4] the moment people start to occupy them they're all 
different [0.8] it's not like a share [0.5] and it's not like a bond [0.5] so 
the moment people start to [0.4] paint their walls a different colour [0.7] or 
put a new garage on [0.6] it's a completely different asset [0.3] so it's not 
homogenous [0.9] so with [0.2] with all of that [0.2] you've got [0.7] 
companies looking to raise money [0.4] with this huge asset base [0.5] which is 
extremely difficult to manage [0.8] and extremely difficult to know [0.6] what 
sort of valuation to put on [4.3] 
so what we've suggested [0.9] in terms of doing this this is for large [0.9] 
property companies [0.9] is to create property derivatives [2.5] and [2.2] you 
can securitize [1.5] an asset [1.2] which means that you could [0.5] 
theoretically take your property asset or any asset [0.3] like [0.4] er [0.6] 
ren-, like er [0.7] credit card [0.6] er receivables [0.2] or [0.6] er mortgage 
pass throughs or a number of other things and securitize them [0.5] and sell 
off little bits of it [3.8] this isn't really appropriate for the property 
portfolio [0.3] of a company because it then [0.2] comes back into stamp duties 
and other [1.1] er front end costs in terms of [0.3] dividing up a property and 
making it into [0.3] a trust for example with little bite size [0.8] so what we 
thought is [0.2] not to buy or sell the physical asset [1.4] but buy sell [0.3] 
and this is another thing or swap [1.6] some of the rental cash flows which are 
derived from the physical asset [1.1] so for example you've got [0.4] a [0.3] a 
company like [0.5] er Marks and Spencer's [0.3] here at the moment [0.6] 
they're not having a very good time of it at all [0.8] and they've just 
undergone a thing called a 
huge sale leaseback [0.5] arrangement [0.7] er that's another way of raising 
money [0.6] for companies is that you [0.4] sell [0.6] your physical assets [0.
5] and then for say twenty years you then lease them back [0.8] from the 
institution or institutions that you've sold them so you get a whole big heap 
of cash flow now [1.7] but [0.2] you're [0.5] hooked for a twenty year lease [0.
8] that [0.5] involves [0.7] huge front end costs again [0.3] and it also means 
[0.5] that by selling [0.2] what is potentially [0.3] your best real estate [0.
5] you lose the real option [0.7] on the real estate [0.2] and it's gone 
forever and it's been acquired by an institution [0.9] so we're suggesting [0.
3] that [0.2] instead of [0.6] selling the asset [0.9] that companies sell the 
cash flows [1.3] and the cash flows are the derivative of the asset [0.5] so we 
can value them using [0.6] derivate pricing theory [1.2] and also bond pricing 
methods [4.5] so this [0.2] is this is what we'll do in an option [0.5] and a 
workshop [0.4] in the first part of next term [0.8] this is how you value all 
real options [1.4] you model the expected performance [0.5] of the underlying 
property or asset [0.8] in a form [1.0] that allows you to assume risk 
neutrality [1.0] it's very important [0.3] that we get into this risk neutral 
universe [1.0] 'cause if we do that then we could compare any property [1.0] so 
if we're in a risk neutral universe [0.2] every asset earns a risk free rate of 
interest [0.4] and we can compare [0.5] the value of any asset so we we have to 
move into a risk neutral universe [4.3] we can take out the expected paths of 
[0.2] any of the cash flows from the asset [0.9] and account for any [0.3] mean 
reversion [1.0] in [0.3] rental growth [0.5] er [0.5] series tend to [1.1] cash 
flows tend to have [0.4] a number of properties one of them is that they're 
mean reverting [1.0] and you'll find this in an inflation series in a rental 
series that it tends to [0.4] it tends to come and tends to revert to the mean 
[0.5] so we can put a model in [0.2] which actually im-, has a huge volatility 
pattern [0.5] but a very nice mean reversion pattern [1.0] and then we can 
discount [0.2] the expected [0.2] rent by the zero yield curve [0.7] of the 
relevant market [0.8] to [0.5] also account [0.3] for mean reversion 
which could be in that series as well because [0.8] yield curves also tend to 
be [0.5] mean reverting so there's a lot of [1.1] organizing that we can do on 
the inputs [2.3] so [0.2] you've seen this one before [2.3] but this is what 
we've used [0.4] for [1.0] the [0.4] the simulation [0.2] part [0.4] in [0.5] 
the option project you're doing [0.9] in the more complex model [0.4] that i've 
[0.3] just put on [0.7] on the server [0.9] this is done [0.6] instead of one 
bullet option [0.6] that we've done [0.4] for your project [0.3] I-E a seven 
year option or a ten year option [0.4] this is done on an annual basis [0.8] so 
[0.2] if you want to use that file [0.3] you can see that [0.2] P-T then 
becomes P-T-plus-one T-plus-two T-plus-three [0.5] as [0.5] it simulates the 
binomial model [0.8] going through time [1.3] the only thing that you [0.9] and 
we [0.2] haven't [1.1] discovered is [0.3] this lambda [0.9] here [2.2] so in 
[0.7] in a real options model [1.8] we have to [0.2] do an adjustment [0.8] for 
risk [0.8] because we can't assume [0.9] that we can hedge [0.5] a real estate 
portfolio properly [0.2] by [0.7] er [0.3] shorting the option and buying delta 
shares [0.8] or [0.6] selling the put and selling delta shares [0.4] 'cause it 
just doesn't work 
out that way because we don't have a delta of a property [0.8] 'cause we can't 
divide the property up into nice little [0.5] bits of property [0.4] in order 
to be able to hedge it properly [1.0] but we can get round it [1.8] by [1.3] 
using [0.6] a CAPM formula which i'll show you very shortly [1.0] so in real 
options [1.6] this mu [2.0] is the expected growth rate [0.8] of whatever it 
might be [0.7] gold [0.9] silver [0.9] whatever [0.4] you're looking at [0.6] 
mu is the expected growth rate of the commodity of [0.3] what's the underlying 
path of the real option [0.9] it is not the risk free rate [3.1] the ad-, the 
variance adjustment's exactly the same [1.2] because [0.5] while options can go 
up [0.4] they most certainly can go down as well [0.2] [laugh] [1.6] come to 
that in a minute [1.4] and the rest of it [0.5] is just the standardized [0.7] 
log normal approach [1.0] that we've been doing [6.3] so you've seen this 
formula before many times [0.2] [cough] [0.9] right [0.3] so it's a slightly 
different guise [0.5] on this one [2.2] so we're [0.5] thi-, this is a property 
based one [1.8] 
where I is a suitable index [1.4] and the suitable index would er [0.5] be [0.
4] say the FTSE All Share [1.5] right [1.0] P is the property [1.4] that you're 
looking at [0.9] if we can [0.7] tease out a beta [0.4] between the index and 
the property [1.4] over some [0.2] period of time [1.1] we could use [0.4] P 
for property [0.3] to resemble if it were that there are several subindices [0.
2] of property [0.4] the same as there are several subindices of gold and 
silver and other bits and pieces [1.1] and just simply use [0.4] what we figure 
out [0.3] the growth is [0.8] less the risk free rate [0.8] and if we take that 
[1.1] off [1.1] the top line [0.9] of [0.4] the formula above [1.4] this one [2.
1] we come back into a risk free world [1.7] and we can then [1.3] discount [0.
8] the cash flows [0.5] in that risk free world [0.4] by the risk free rate [0.
7] so we're just doing [0.6] what you've been doing all the time [0.2] it's 
just a a CAPM adjustment [0.6] to bring [0.3] the whole thing back [0.4] to 
risk neutrality [2.1] which is extremely useful because it means you don't have 
to form the portfolio [9.4] so if you've got this process [1.1] for property or 
for gold or for silver or for whatever [0.5] the real optionality 
of it might be [1.5] the [0.4] the cash flows [0.8] inherit the stochastic 
property [0.6] properties [0.4] of the underlying asset [0.7] so all of the 
cash flows [0.4] will be stochastic as well [0.7] as the property moves around 
[0.4] any cash flows [0.5] which come from it [0.2] will also tend to be 
stochastic [1.1] we discount at the risk free [1.4] rate [1.3] now [0.6] there 
are important parts going back to the property portfolio [0.4] and this will 
depend on the market that you're in which i i'll come to shortly [0.5] we can 
separate [0.9] this property [0.3] cash flow into fixed and variable 
characteristics [1.4] and we can then analyse [1.5] any of the characteristics 
[0.2] of [0.3] the cash flows [0.9] to account for [0.3] jump diffusion what's 
jump diffusion [4.2] where are [0.3] the mathematicians [1.2] what's jump 
diffusion [4.2] [whistle] [laughter] blinding silence [3.8] it's what happens 
when a market falls out of bed completely [1.3] so what you've er you've had a 
little bit here [laugh] right [0.4] that [0.2] one of the the problems [0.5] 
and it crashes as well [0.6] one of the problems with a standard Black Scholes 
methodology [1.1] is that it assumes [0.6] that [0.7] markets [0.3] go very 
nicely and very continuously [0.9] they don't [1.3] so what you've got is [0.3] 
you can model [0.5] into a process [0.7] either a jump diffusion on volatility 
[0.2] which means that volatility in a market suddenly changes [0.6] and as you 
will have [0.6] been with Dr Smith [0.2] who has nice little volatility change 
regimes [0.8] from time to time this has amazing impact [0.3] on what happens 
with a market so you can model [0.3] a process of [0.5] volatility diffusion [1.
5] that it [0.3] goes [0.7] over [0.3] a shortish period of time [0.5] that m-, 
people's view on volatility [0.4] say over a week suddenly changes [0.3] and 
they assume that the market volatility is going [0.4] up or down [1.1] 
er [0.7] that's not as bad as a crash [1.8] but you can also put a crash model 
in [0.9] you can assume that er in the next ten years [0.5] for example [1.0] 
that [0.5] the stock market or the gold market [0.5] will crash by twenty per 
cent on a given day [1.3] now you don't know when the day's going to be [1.1] 
but you can [0.2] probabilistically [0.2] weight it [0.6] so that at some stage 
[0.3] through the next ten years [0.4] there is going to be the most [0.2] 
almighty crash [1.2] that could happen in any market [1.4] er as i say we can 
[0.8] model for mean reverter yields [0.2] and we can model for mean reverting 
interest rates [0.6] so [0.4] anybody that's looking at raising money [0.2] on 
this sort of thing must [0.5] model in [0.5] the fact [0.2] that [0.6] markets 
fall and they fall very quickly [1.2] they tend to rise rather slower [laugh] 
[0.5] so you can [0.3] put all of this modelling in [0.9] and er [0.3] and get 
yourself [0.4] quite an acceptable valuation [0.6] in order to go out and get 
some 
money [2.8] er [1.3] this is where [1.1] in [0.3] financial engineering terms 
and raising money you can get quite clever [1.6] there [0.4] there is a 
structure [0.3] in this market [0.5] and in a number of other markets [0.6] 
which is called an upward only lease [0.5] a lot of companies [0.6] do this a 
lot of companies [0.3] lease [1.0] for a long period of time [1.6] and they 
don't lease on what's called market rental [0.4] that means their rents don't 
change every year [1.1] as a function of open market [0.6] their rents may 
change only once every five years [1.5] and if the landlord can get away with 
it [0.6] they only change [0.2] upwards [0.7] they never go down [1.9] this is 
a [0.2] an incredibly iniquitous form of lease [1.0] but in a tight property 
market [0.8] it sometimes happens [0.7] that you can have [0.4] upward only [1.
0] leases so if you have upward only leases [0.8] the first part of a five year 
lease [1.8] if it's a good credit [0.7] is actually an annuity [1.4] so what 
you've got is this company is paying twenty-five years' annuities [0.7] to 
somebody [1.1] 'cause it's paying [0.7] at least that amount of lease rental [1.
3] for the next twenty-five years [0.6] so 
you can take these [0.5] annuities [0.9] package them up [1.2] put a bank 
behind it [0.4] and securitize them and sell them into the bond market [1.9] if 
you're a good treasurer [2.1] this [0.2] what i've called second slice th-, [0.
2] these are five year [1.0] this second slice is unknown [1.8] so if it's 
unknown [0.6] but it's high volatility [0.6] it's an option [1.9] so [0.2] you 
can sell [1.4] the next twenty years [2.0] effectively convertible bond [laugh] 
[0.4] effectively an option [0.5] for twenty years [0.3] you can do the same 
with a green lot which is the third slice [0.6] for the last fifteen years [0.
7] so by the time you've finished [1.1] working out where your property's at [0.
8] you can have the physical property or the physical asset [1.1] still keep it 
[1.2] because that's the most valuable option [0.3] in real option that you've 
got [0.7] but you can sell [0.7] all of the cash flows [0.6] which are derived 
from the physical asset [0.7] so by the time you [0.2] can mix and match [0.3] 
you've [0.9] sold an annuity [0.6] sold several slices of options [0.2] and 
kept the property [1.5] so a property in central 
London or central New York or central wherever it might be [0.5] even central 
Reading [0.9] in twenty-five years time [0.4] might be worth [0.3] a whole heap 
of money [0.8] so you're not giving it away which is what the Marks and 
Spencer's [0.8] model was [0.6] that you're actually giving away what's called 
the reversion [0.4] in real estate speak [0.8] you're giving away your most 
valuable option [1.2] rather than [1.2] being smart and using [0.7] optionality 
[0.5] to raise money [1.0] to get your cash flows up [5.9] so this sort of 
structure [0.4] and any sort of structure [0.4] based on [1.2] real options [1.
6] tends to minimize [0.5] legal fees [1.3] er [0.2] and valuation fees because 
you're not [0.5] doing the whole of the asset we're just doing the rentals [1.
1] you can [0.3] in property speak [0.6] er the covenant [0.6] is the company 
that is [0.2] renting the property [1.2] you can credit enhance [1.0] we 
haven't covered [1.0] enhancement [1.1] but you can credit enhance so if it's a 
weak [0.5] company [0.8] you can go and find a bank [1.3] that may have a 
relationship with [0.2] this company's parent [0.8] and may [0.3] put a bank 
guarantee [0.9] behind [0.5] the payment 
of the cash flows [1.5] and [0.4] enable it to be sold into a different market 
which is the [0.9] securitization market [1.2] so you can then [0.3] parcel up 
all of these little cash flows on gold or silver or property or whatever it 
might be [1.3] break them down into bite size chunks [1.0] enhance them so it's 
er instead of it being er namex Enterprises Credit it's Deutsche Bank and 
presumably Deutsche Bank is a bit [0.2] better credit than i am [1.0] and then 
[0.6] sell that as a Deutsche Bank piece of paper into the market [0.6] if you 
can do that [1.7] what it means is [0.3] that [0.4] you never part with the 
asset [0.6] and you're using [0.2] other [0.3] parts of the capital market [0.
7] to reveal [1.1] the real optionality [0.7] that is in [0.9] your company's 
assets [0.8] and the ones that we've looked at [1.1] the sum of the parts [0.3] 
greatly exceeds [0.9] the total [1.1] that when you [1.1] use the real options 
[0.4] and peel them out [0.9] that [0.4] what has been [0.6] the passive [1.1] 
net present value as we did in the workshops [0.6] is far far less [0.8] than 
the optionality [0.2] of the cash flows [0.3] properly engineered [0.6] and 
properly put through [0.5] 
into the capital market [1.1] now [0.8] one thing that [1.0] you can do and 
this is just [0.2] from [0.6] the investment regime [0.8] just as an investor 
[0.9] that if i'm Long Reading Property [1.2] and er [2.3] namex is Long 
Birmingham Property [1.6] then [1.2] maybe i'm a Little Too Long South of 
England Property [1.2] and [0.3] er i'm [0.4] not really happy with the 
economic characteristics of [0.5] the south of England i'm too long [0.6] and 
he's Too Long Midlands [0.6] Property [0.9] so we could actually swap [1.1] our 
property exposure [0.7] for a while [1.1] so [0.6] namex could sell me [0.7] 
his [1.5] next ten years Birmingham rents [1.1] and i could [0.2] s-, sell him 
my next ten years' Reading rents [0.7] so instead of s-, instead of us both 
going into a transaction [0.4] where we have to sell the property [0.5] we 
could go into a transaction where we forward sell the cash flows [0.8] from the 
property [0.5] so then [0.2] er my a hundred-million Reading cash flows will go 
to him [0.7] and i-, er [0.2] well in [0.2] net terms er [0.2] and his will 
come back to me [0.4] and at the end of the process [0.3] like in the swaps 
market [0.5] we simply net out the difference of the cash flows [1.1] 
so that er namex may win [1.0] because [0.2] you know he's bought my Reading 
properties [0.2] and he's made a good deal [0.7] but i might win on the other 
hand but we don't swap the gross [1.3] cash [0.3] we swap the net cash [0.2] at 
the end [0.9] on ongoing basis [0.6] so it's a very [0.3] useful area looking 
at it from the investor rather than the company that's trying to raise money [0.
8] that er i can diversify out of [1.1] a market here [0.5] into [0.3] another 
market [0.9] er which [0.7] er might enhance [0.5] yeah my overall [0.3] 
diversification potential [9.2] there's a couple of the markets which i've gone 
through [0.7] which [0.6] er [0.6] which might [1.3] want to use their assets 
[0.6] certainly companies [0.3] when they are raising money do not use [0.7] 
their property assets [0.4] properly [0.5] Marks and Spencer's is the latest 
classic [0.5] why sell its best properties [0.6] into the market [0.8] and then 
rent them back [0.9] and give a buyer a Marks and Spencer's credit 
which is still extremely good [0.6] is entirely beyond me [0.9] as to all they 
should have done is to securitize the cash flows [0.8] sell the cash flows into 
the market [0.6] and keep the property [0.7] so there's a lot [0.9] the message 
from the day is [0.8] there's a lot of hidden value [1.1] in [0.2] all of these 
asset classes [0.9] particularly in [0.6] the propert-, [0.3] the property [0.
4] portfolio [0.8] of [0.3] the company [0.9] okay [0.6] so that's [0.3] that's 
a first look [0.6] at [0.5] real assets [0.4] sorry real options [1.0] er [0.9] 
one modelling [0.2] session [1.0] next term [0.3] where i'll show you these [0.
5] and i [0.3] show you the models [0.4] for deferring abandonment [0.3] 
they're actually reasonably simple [0.6] in terms of [0.5] getting out the [0.
3] the cash flows [0.7] getting them through [0.9] so [0.7] that'll do us [0.5] 
for today i'm going to be around until eleven [1.2] i know people want [0.5] to 
talk about projects [0.4] so i've got a meeting at eleven until twelve [0.8] 
and we'll [0.3] pick up any other meetings [0.4] next week [1.1] okay