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