Option value

Abstract

The value of being able to put off decisions. If one invests in a project now one’s capital is sunk in it. Market conditions may then change to make the project more or less profitable. If the decision is deferred, one can invest next year if the market improves, or abandon the project if the market worsens. Option value is the expected benefit from delaying a decision. The option value of ability to delay investments helps to explain the existence of liquidity preference, since holding cash does not commit one to any particular form of future expenditure. If a market is expected to improve rapidly, or there is a danger that competitors may enter it first, option value may be negative, in which case it pays to invest now. Option value also refers to the determination of fair prices for call options and put options.