-- JohnFavaro (also thanks to MaroanMaizar)
In particular with options on traded assets more uncertainty == more value and expected return on the underlying thing is irrelevant. In options on non-traded things this isn't necessarily the case. This is because with the traded asset you can (in theory) have a strategy to continuously buy and sell it and end up with something that behaves exactly like your option. You can't do this with an option on something which is not traded.
Actually, "more uncertainty = more value" even if an underlying asset of an option is non-traded. This is an artifact of an option's non-linear payoff. By definition, the payoff function is skewed towards the upside, so when you increase uncertainty, you increase the upside potential, but the downside risk remains limited. So the option value, which is in essence an expected value, also increases. The rational exercise principle -- i.e., exercise only if expected payoff at the time of exercise is positive -- ensures this. Tradeability has little, if any, to do with uncertainty-value relationship.
For valuation purposes, financial option-real option analogy may indeed be iffy. As a reasoning tool, this technical assumption is not that critical, especially when comparing alternatives. Think of option value as an "idealized value" relative to a hypothetical benchmark (an imaginary trading strategy replicates the payoffs of the option), as a ranking metric, not as fair market value. Besides, not all option pricing methods rely on traded-asset assumption. Use your favorite option pricing technique. It is even possible to get significant insight by valuing an option through good old decision tree analysis. Risk-neutral valuation, a popular option pricing technique, is attractive because it requires less information although it relies on tradeability. It's also easy to combine with decision tree analysis. Otherwise one needs to explicitly estimate a probability distribution for the payoff, which is not less problematic than tradeability.
-- HakanErdogmus (June 24, 2002)
Could the option to grow be the same as the XpMayScale?? Or perhaps XP abandons the value of this option in favor of the value of the other three. More the latter, I think
"Option to abandon" doesn't seem quite right: I happen to be reading the ProcessPatternsBook by ScottAmbler this week, and he hammers home that in the "Justify Stage" (one of the first things one does when a project starts), one must determine if the project is feasible, and kill it if it's not. I think that most methodologies do at least lip service to the planned "cancelability" of projects -- at the beginning, during the project approval process.
(In practice, the "Justify" stage is used to perform heavily slanted sales presentations to the GoldOwners. But that's another issue. ;-)
I think a big advantage to IncrementalDelivery is that it gives the users the option to abandon the project at (nearly) any time -- and still preserve the value (development effort) that has been invested thus far. That is, you have the "option to abandon, and declare the project a success."
I think the "Growth option" with XP would be related to maintainability: Because of DoTheSimplestThingThatCouldPossiblyWork and RefactorMercilessly, the system is highly maintainable and can be changed easily. With waterfall development, flexibility in ways that were designed into the system early on is easy, but changing the system in other ways is relatively hard.
Found this reference:
"Software design as an investment activity: A real options perspective," K.J. Sullivan, P. Chalasani, S. Jha, and V. Sazawal, in Real Options and Business Strategy: Applications to Decision Making, L. Trigeorgis, consulting editor, Risk Books, December 1999, pp. 215
Anyone read the book?
I haven't read the whole book, but I read the chapter by Sullivan et al. The authors discuss how to reason about some software development strategies as real options using decision trees and dynamic programming. Another article on software investments and real options is "Value Based Software Reuse Investment", by JohnFavaro et al. in Annals of Software Engineering, Vol. 5 (1998), pp. 5-52. John and I also wrote a chapter on this for the book XP Perspectives, entitled "Keep Your Options Open: Extreme Programming and the Economics of Flexibility". You can find it at http://xpottawa.ca/public/wiki.cgi?HakanErdogmus or at http://www.favaro.net/john/home/index.html -- HakanErdogmus
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