Evaluating a Real Option in Material Procurement

This paper describes how to evaluate a long-term fixed priced material procurement contract versus spot purchases. We model the long-term contract as a real option. In the financial world, option pricing is based on the assumption that the market is complete and frictionless. This assumption is usually too strong when it comes to pricing real options. For example, both the option and its underlying asset are not traded in an efficient market. Our methodology does not require market completeness and uses some of the latest research in finance such as projection pricing (4), correlation pricing(5), zero level pricing, the Ratio Theorem (3) as well as some lattice techniques (2). The option results in significant cost savings due to the ability to change order sizes while keeping price fixed.