Options are financial instruments that derive their value from underlying securities such as stocks, bonds, etc. These are common in options contracts which offer buyers the opportunity to buy or sell the underlying asset in the future. However, it does not oblige them to do so. Instead, they get the right to the purchase or sale of the underlying asset.
Options come in different forms. The classification depends on several factors. For example, call options allow holders to buy the underlying asset while a put option lets them sell it. Similarly, options may come as real and financial options. Both of these are different. Therefore, it is crucial to understand the differences between them.
What are Real Options?
Real options are mostly applicable to company management. These give a company’s management the right to undertake a business opportunity or investment at a specific time. Real options get their name from the fact that they involve tangible assets instead of financial instruments. Usually, most options in the market involve an underlying financial instrument. Real options don’t and are, therefore, rare.
For companies, real options are crucial for long-term success. These options provide companies with the opportunity to choose the right business opportunity. Through this, they can increase profitability and growth. With real options, a company’s management has the choice to make a decision. Similarly, they get the right to reject or abandon a decision, which can be crucial sometimes.
Real options can provide a company’s management with several types of decisions. These include options to expand, abandon, wait, contract or switch. Since it depends on decision-making, real options get their value from relevant techniques, for example, Net Present Value. The price or value of a real option may depend on the type of decision it contains.
Overall, real options relate to decisions and do not have underlying financial assets. These apply to the management of a company or business.
What are Financial Options?
Financial options are derivatives contracts that get their value from an underlying financial instrument. It may include stocks, bonds, or even an interest rate. Instead of relating to decision-making, financial options provide holders with the opportunity to buy or sell the underlying financial instrument. These options also come with a time and price specification.
There are two types of financial options that are common in the market. These include call and put options. As mentioned, call options give holders the right to buy the financial instrument at a specified price at a specified future date. Put options, on the other hand, come with the right to sell the underlying financial instrument.
Financial options are prevalent on the stock exchange. However, they may also come over-the-counter. Holders can use financial options to hedge against risks or increase their future gains. Unlike real options, financial options don’t get their value from capital budgeting techniques. Instead, they consider several variables.
Overall, financial options are derivatives that involve an underlying financial instrument. These do not apply to the decision-making process, unlike real options.
Conclusion
Options are financial instruments that derive their value from underlying securities. There are various types of options that may exist. Real options include derivatives that get their value from future decisions. These give the holder the right to make a decision in the future. Financial options are derivatives that get their value from underlying financial instruments, such as stocks or bonds.
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