Eight. Capacity Expansion as a Contingent Claim: Flexibility and Real Options in Operations

  1. Panos Kouvelis2,
  2. Lingxiu Dong2,
  3. Onur Boyabatli3 and
  4. Rong Li3
  1. Bardia Kamrad

Published Online: 11 OCT 2011

DOI: 10.1002/9781118115800.ch8

The Handbook of Integrated Risk Management in Global Supply Chains

The Handbook of Integrated Risk Management in Global Supply Chains

How to Cite

Kamrad, B. (2011) Capacity Expansion as a Contingent Claim: Flexibility and Real Options in Operations, in The Handbook of Integrated Risk Management in Global Supply Chains (eds P. Kouvelis, L. Dong, O. Boyabatli and R. Li), John Wiley & Sons, Inc., Hoboken, NJ, USA. doi: 10.1002/9781118115800.ch8

Editor Information

  1. 2

    Olin Business School, Washington University, St. Louis, Missouri, USA

  2. 3

    Lee Kong Chian School of Business, Singapore Management University, Singapore

Author Information

  1. McDonough School of Business, Georgetown University, Washington, DC, USA

Publication History

  1. Published Online: 11 OCT 2011
  2. Published Print: 4 NOV 2011

ISBN Information

Print ISBN: 9780470535127

Online ISBN: 9781118115800

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Keywords:

  • Black Scholes option pricing model;
  • capacity expansion option;
  • contingent claim;
  • financial option pricing model;
  • Merton option pricing model;
  • real options valuation (ROV)

Summary

Contingent claims methodology have had a considerable impact in the integration of financial risk management concepts in operations and related capital allocation problems. The methodology has also helped in expanding the set of needed tools for evaluating risk-based decisions through providing an alternative economic platform for analyses. This chapter provides a prefatory introduction to these concepts by reviewing their application in the context of a capacity investment problem where the flexibility (real option) to expand capacity remains a future alternative. The strategic insights and the intuition resulting from the approach are detailed and calibrated relative to the more established decision analysis approach. The chapter reviews the Black and Scholes and Merton option pricing model. It highlights the advantages of a real options valuation (ROV) approach.

Controlled Vocabulary Terms

Black Scholes model; Capacity planning; Financial risk management; Real options valuation