Pricing Real Options Contracts in Capacity Exchanges

Google Tech Talks
October 20, 2006

ABSTRACT
First talk (joint work with Dr. Shijie Deng of GT) is a theory piece where we propose to create industrial exchanges for capacity trading via options contracts. In a continuous-time setting, we study the pricing of tradable capacity options contracts in business-to-business (B2B) exchanges in a variety of industries such as contract manufacturing, semiconductor (e.g. memory chips), oil and gas, electric power or commodity chemicals. The contract takes the form of European call option that specifies a premium price and a strike price. We show that the real options pricing formula is a modified Black-Merton-Scholes pricing formula and is equivalent to the...

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Closed Caption:

so we had here with us detail was out of
my professor at georgia tech
sia diese professor of information
technology management address expands
yet to see some more and
and if you have a little occasions then
the whole one says
different journals such measures science
journal of medicine information systems
european journal of operations research
design support systems except
so it now for their do de do
exetel
and everybody at me
i think you are
the incentive for me to be stu group
believes that people my teaching say i'm
teaching his electronic commerce kos sa
so we have found so lots of n_b_a_ said
in a city who was a mustard each case so
i want to a comunicacao visits out to
check out the weather
you have free lunch here on us
hosted by the free lunch and also to
learn how to play llego
but then i said is the latest on this as
a table top as a guy soon enough
course had talked about
so that i sent him out to be talking to
said so i'm not
yet he actually maybe take either date
at this proposal and i did that since
they know what i don't have been a big
deal out a so i don't even due to the
top sierra of
but sites that work in progress is
ongoing project at the georgia tech com
so i'd like to keep the talk of a resume
formal aimed at interactive com
and you can ask any questions for me we
don't have any confidential question a
opened a resurgence
yet this talk and it's all part of our
price here we are options contracts
aren't
incapacity exchanges i said johnnie
walker with professor suji attend for
the
uh... school of industrial behind the
systems engineering at georgia tech com
so the both animation of these
researchers are is really the internet
strategy that has a really uh...
revolutionized the definition of a
market interview factors creator many
new imac twenty marketplaces
how global is acting must each case
and that the other sister i won't
comment on the right was a google ocn
abu
we have a proposal for you
while me here is that i want to discuss
with you later this evening
them out of you know they did see your
own so here is the idea of how we have
been thinking of a long time market so
it was the next thing that we have all
of us new markets and was the new her
yesterday and we can do
it's a smart markets are far capacity
trading
him
the idea is uh... very simple
okay the idea is sound
superhighway to offer
capacity as the options
it's difference blood and then doing now
lol cal actor used this example sa
imagine haha yahoo just imagine said
they are all case kansas or seen
for memory chips from our supplier in
china okay
just imagine this company called fox
haha dead i'm not sure this is a really
true business but here is up bhaiyya
at the supplier sit up
said i want to buy a memory chips
for the moment so what's up they do is
to me that they signed the domestic
contracts
but i have to buy racer for example of
that say about which uh... a particular
contract the cesar solomon units of the
memory chips
fit for me to produce
new another dell computer dot com
then
so how much should i sayed events was my
supplier
yaar if i sign a power locks
you have been studying the process
desired change see i don't know actually
my market demands for the case
for january till seven th could rehired
could be a little rights
and so i don't know what means how it is
going to do it
hedonistic egotistical at is keeping a
lady in now
so what we have to do in the process
industry
they have a new release civil particular
setups that would leave the u_n_
exchanged a k
so you have a new release what do i do
to win this community in the stuff i
signed to not have to buy
so therefore the ideas what-if
we don't actually signed a contract for
actress starfleet evidence
how pilots we signed this capacity as an
option
and saeb
by next january i could exercise my
option
okay give
you know i do need to those memory chips
okay
otherwise i could to us
not exercise i can choose not to
exercise
so that's the basic idea
so what i want to proposing his own
is a continuous arching of those
capacity options
it's a boxing of
options
so that's the babies in what doing
and the wind this annual yes because
right here we have to locketts a tape
the first marketing is we've caught the
contract model market all office market
all of the advanced the market
so here are heads right now i'm going to
contract with a capacity
and for memory chips
and also i have a spot market c armored
day say january the first two salmon one
nine e the stuff i need to the memory
chips right
so there's a price right there that's a
spot price
i want to reintegrate those flows prices
so you know that's the beauty of the
internet's previously
it's separated
so now we actually have opportunity to
actually took the integrators to markets
right
the fort market all the options market
and the spot market
the way i'm going to integrate them is
using his idea of cold we options from
uh... from final
so that's the basic ideas it would be
until
continuously
three action
those
capacity
options ticket and those option soon is
that really had a real office contract
so thats
can come act
therefore market office market
and the spot market
so what's not what you missed talking
all all all contribution you so we know
we actually have a continuous-time model
of capacity options trading
so you can actually marketplaces
so you see all they know the stuff you
can go out
that's that's the day you know that's
all hundreds of discussed on
sit down
yet this is elite they know so you hits
a
resizing example okay
yahoo
let me again using dale as example but
it may not be true tend to see those who
like to use outside names the deviated
idea
suppose i want to buy stadium at memory
chips okay
say for the moment okay if they could
ninety percent in all of these uh...
delis contracts in as a
big into give to our long-term hauling
incumbent supplier okay so this is
somebody
they have been doing business all long
time they've known and for the rest of
faith ten percent off those are
capacity ok without
or they're going to get it from the
young spot market often up from experts
change okay
it's it's a very small percentage with
mother of a ten percentage
the reason yes they are the consignee
saying no my second tough to talk about
those nam price attributes like a
quality
and they are also relationships into
long-term relationships
to the trend in that industry right now
it's the court code the structure of
sourcing what they're doing is our man
so they want to be able to hates pricey
her because uh... i don't know the price
next january so you know see i want to
be able to hates the price also to be
able to
page my shot each year by the time i
needed to i want to make sure i can
i think it is
and that also-ran save costs ok bail
sri goes so you have to decide if i
three goes h price
hate to risk
and also uh...
save cost effective
so we're going to claim you know we have
a model we have our contract actually
can
help forms the satisfy
all three criteria
yet this is a good thing another example
is about the electric
onward markets
send them but i'm not to go over a
services that they would have been
working with uh... myata by settler
tonight paul climbed offer her haha
for over a decade enough but the same
light beer
so the commonalities that this the
following salameh spent some time to
uh...
to really laid down seasoned the problem
here
if i can tell you the problem dot
indicates that you can solve it
so the problem here is a gear we have to
market
so you have this contract markets out
there let's just assume it's a year
ahead okay
i'm going to us i mean you know so you
have
where is the most fighters save
in china okay
of falling estimada monster
signals are billion-dollar contracts
that i've been as it could be a year
came app
then we have a small markets are depends
on what we're talking about the
electrical power power is happy ten they
had a few such an ob
and uh...
but for memberships who can be just on a
day com
so you have to market the contract
walking away a half and then the spot
market
to what well proposing between so you
can trace
see let's say again i think he about to
us the let's say who is that in this
kind of contracts it for example it sir
tsn scenic taiwan semiconductor
manufacturing company com
so they are sent to you
that let's assume that stale uh...
tradable cut capacities all seven into
intel does treatable capacity options
okay
but you know in between and you may
trade
civilians on the following okay
six first before the suppliers are going
to be its okay the contracts and also
the capacity
suppose i have
a pickup acid that's make it simple and
that's a a hundred okay
but i don't have to tell you i can sell
a hundred haitians zap it decided to
visit
say how much to post into analysis so
that he knows it because if i post a
hundred you may take the hundred right
but i may save some i'm a week or some
of my capacity because is a trading
going on today
here we are talking about the business
is on the day
so those are plenty of room she missed
it for you to play
so the suppliers what they do is that in
the beats
those office contacts
the options as
two apartments are standards
the first part is that a reservation fee
second by his execution feeding
you first have to pay
safety s_n_c_ price
enough for you
so you blessed two dollars per unit so
i'm just making that to reserve the
capacity for u mccain and holiday so if
you want to actually exercising to buy
this
so you paid some additional execution of
your striking
this is also called a striking price
a dollar or two dollars secure extra ok
to actor that he was the stuff
but if you don't want to exercise your
options contract you don't have to pay
execution
and there haha they have decided to see
how much capacity the coast
now what the buyers in this idea
sinister whether to buy those kinda
options venus and how many options ok to
contact the indebtedness
so that's the bios this issue
and in the process you know they could
updating of the information sir don't
know what's going to happen sit on a day
they don't know civil than said
generally see what the market looks like
so in the process
boast parties
boasts the supplier and
the buyer
note that cuban to update to the
infomation okay
then for the event of a just a bill
decisions
how can the sound
the supplier just because he knows he's
new adjust the reservation fee executed
b
also he s dot com for
the rate of release of the capacity is
different way yes
again how much capacity pulsed c
you can think about every day
over the time
and the same time gives the buyer they
have to think he is in a safe weather
should i buy a lot okay
then also you know so you have to think
you have to which the rate catered to by
hasn't
supplies keeping posting so they have to
decide whether to buying on the whole of
the time
so that's the innocent
he between what happens okay and they
actually they can trade here right neck
and trade the peak framework years
they can trace
buyers can by more than it needed to
them they can sell packing it in the
contract because they have different
beliefs right
yeah about the state of the waters
in all of these missile partisan virus
email say they have different needs
never been a discovered in a city
which market is selling warehouse a wet
these forms that global firms
say particular product id
and if not setting where he had silicon
valley msl wearing atlanta
all you embedded in china
housing at the end of the actually has a
campaign check across the world
also that's why you have to be going on
then amadeus up the supply decided to
whether to cell residual capacity they
may have raised a capacity right on the
spot market
on knot's okay
the buyer has to decide
they've been at the site of a hump how
much to exercise so far he has
accumulated for the biochemical illness
capacity options okay
then holiday
to happen
we have to decide up a tom
how much to exercise smith from
qualities you know so you pay the
reserve capacity
also how much to five eight from the
spot pocket you know so you don't have
to buy it from those this options right
you could actually in sourcing entirely
oil needs right from the spot market if
the small market to give you a good deal
tell you with me
so you know that's the whole time on
what's going on
and uh...
so im i'm going to present a model ob
that can be held on the idea is only one
supplier and
won by
okay let's say how can we solve this
problem
any questions you know this is your
basic setup that's the problem we are
looking
before we have to do this continues time
let's say whatever that's on its roof
unit
okay hob
suppose you are not allowed to trace
okay you can contact the contacting them
and say you as a case
and you have to market
contract market
any options market was going to happen
we have to solve this problem already
are
certainly swiss army yeah we sat through
several repair researchers are
why is this process that you dont from
mom
yaha i think it's not hong kong
university
the process of for climbed over who
it's not too keen see at near
what we do in the sun
sleepiness tool markets must again take
a look at it we have pappas contractor
you have the reservation fee at the
execution fyn
and this chapter two and yes the optimal
contacts of the highest in the reserved
from your supplier
and sab we also have a spot market price
p_s_ right there is open
and sound
and we have to mean that the spa market
price and that we also have a measure
about spot market that could be
predicted
so this picture after tell ceo
get a solution for this tool here it is
acree
very simple and a very intuitive
what shows up here so you few traveled
more since the price of the real option
and satire
if you travel
east's okay
yes
tell seriously executed the price we did
that transformation
so this chats resume shoes because they
saw options
so i'm a day of yup
what's up a new stuff prices though
mini mountain of the spot price
anzio execution fees thanks so you have
been a you going to pay whatever is no
worker
so that's out that's the only ten
notations of transformation
so want to do that as a nation
the optimal solution used in straight
lines you know c
forty five degree like the other way
though
so on
concede that one can tell you
when these guys they have incentives to
trade when they don't okay
so all you have to do is
you do this in depth aggressive eighteen
feet plus the effective
pricing and as i would call this the
fact that price
okay equal to the mean left the stock
market price
you have this forty five degree line
so if any supplies into
postal contract okay
into the buyer does the calculation is
he's bigger than i mean that's what
market price they're not going to buy
finding a way to finance
i'm not going to pay more than the
meaning of the small market price of
doesn't know trade here
on the other
kent are
c the suppliers they also need some
incentive to participate beneath you to
pay means something upfront tourism
capacity for you
so otherwise
you know i can't wait to see why should
i sell unanimous okay to you
so they'll fight army that made up
triangle area okhane
is that trading area okay so do you
suppose parties you know say they have
incentive to trade
for capacity options
and this right away if you can tell you
exactly what they often are resonating
for the buyer is activated simple is
this capital u is still you took the
function okay
this new prime news
the bios women's
we miss the pay right
you've got the interviews in queens you
solve this one
this accident near the bottom of the
past the reservation
before the fire
so you know
that the suppliers to take this into
consideration
okay this is difficult game theory
and then this tape
what should i set my often will contract
and we proved that the optimal
contracting is active for the supplier
to tell the troops
to have to charge the production cost ok
execution feeds them
set the execution of the exactly equals
two
they'll marginal production cost don't
make money next rocking price setting
rob and making money
by releasing your reservation fee
so that's the news about sulekha
overview a previously known researcher
what we did
so that this point izak rebate quinlan
point equally pinpoint
and that's the packaging staying up
uniform market nancy
what's the price
thus supplies and assess
for reservation fee excuse you feed
and how much the bios interests of the
evidence and all that day
see what's the nam
what the bios tended to be at stake into
this invoice we'd compare the spot
market price was asked to should be
whichever is lower is going to do that
today
n_p_f_
spot market prices higher
then they're going to
exercise the options ok and uh... new
factor
they'll be into use all of the past say
they have uh... reserved
so that's what we do it in his toolkit
model
but he won of course ak you could do
this proposal to have lead us to
exchange to trade
we need to solve this continues time on
the home
so they'll fall
you what applies to actually to go ahead
and set up leads us to exchange for
capacity options
we need to answer the following
questions
the first squashing is the same like
this to view it ok so what is the buyers
off the muscles and strategy
taken this into consideration
what is the suppliers often or update
setting strategy
kelby trina strategy based on how they
should
how the supply should be it
you could imagine off
their select twenty bulletin boards two
cultures
the supply a bit
unique wpm okay
at what is the price of capacity options
and how does it compare with financial
options
that because uh...
new york stock exchange you know we all
know that's an unfair how does the
difference and now
we also have chicago walking right
change nized so they'll form
how to come here so the price of a real
options
vs
the price of financial options night
how do they differ
when do that com words
so we need some make of the inca trades
to this intellectual heritage
art van how does this tool marcus
prior school more right now i have to
price it say
we have the stock market prices keeping
movie
stochastic lee
but you also have this
contract price rights keeps going right
what's the relationship between his two
right
so how do they called me we need to be
answer those questions
and also lol
it's from the operation up one of them
to you with a one hospital fastidious
about k
so what we have to spot market prices
really bala tile writes that day
soon then
so
is this capacity options
more valuable
into each of you think that's true that
i am so why would you like to bypass the
options we options
peg if they are a lot of risks rhinos
bull market in particular when you have
a huge volatility indicate
here that's going to issue we need to
check whether it's true or not
the second thing as
so far
you find scientists i'll be right with
you notify us find this okay
where had saturday
is that somehow to hire to the body or
not that is the code time to deliver ok
so she misses
yet those kinda capacity options okay
so use that to me
you know the thing to do
word here
i sign
wists the supplier
and the more valuable to the by or not
smoking in treating you may think it is
to but we need to check it out
yes
visualize
wrestler and he has an awesome
may save you
yeah all of it by the first question yes
do i have seen
he's already said hey
if i can ourselves stuff and i a l
and i saw in this particular model
we don't listen that's obviously there
are a lot of apollo rocks
it's a hard
to us and so on
so you can see there
we asked where starting
parrish melissa
snowstorm
the second question here
hosea haha
twenty two ninety eight
the applicant seeking stories as a
special case
on oxygen
but as you know you know
but he just doesn't come out there is
enormous tools julie danis yahoo
so those are questions that we had
telecon and some people we have to go
and this is again this time hi nahi hai
i went over the edge of his assistant
for welfare issue
even sending last color
television ideas obviously hit
again the idea is that hall archie
bunker passing so i mean just give it to
you
this model is uh... it's a simple one
what is it
was that i want my ear
of the salary is that of the funds that
were meter
and is that i think it's a technology in
a city
the middle of the easiest
cost if i don't want
production costs
is that
you tell us flat objetivo on renegade
but is the big one you know how you can
thank you tom
powerful and they have a capacity
you show us how we cannot change because
once you hear that
so those guys that type of maximize
millions
they are off
topsy photo
to get a stateside and all my love
innocent executed he is tuesday
ivy salt
this time so you know
yet but
the masses i've seen
okay you're not going to make money at
sufficiently therefore there's two
things
the set-up and control when is the price
of the obscene over the time
and the second two years
you know how i did not really sick
comunica passing on a pollster over the
time
virus utility maximize
minds are sick
overtime is accumulating
he's options those on the actually not
the number of membership see already
purchased is accurate
who's off sixteen he has the right
but he has not even or just yet
so basically he's lost only
recently purchased the rights okay
on the day to use
but he's not going to store orders
memberships you know sinning
places away other houses
the spot price nobody came
control walking away assuming follows a
stochastic process in the nobel control
on the stock market pricing
that's like a global
mendoza market price for memory chips
what wet willies nearly we try to extend
the only what we did for to get to the
company has time
okay i'll
we have to have a formation of a problem
nuggets get better
policy are you really want to but i want
to begin a close your eyes virgina
people where do you know you have to
form this continues fine
model for the fire
and yes we can solve its ok let me tell
you what the solution looks like okay
tax also which is a bad bad solution
the bias can apply whatever the posters
has limited
our capacity to give up
and uh...
yet but i'm not at the time of the day
you want to have to do you see it
is exactly the same position pads are
typically published so
so you know that's there yeah that's the
solution
the sad i was going to take all this
into consideration so there are problems
that
this problem because i don't want to go
over because general
only defeat
like twenty minutes
community there's no way i can finish it
up
magnetized a_a_r_p_'s award it's going
to watch you know what you might have
mathematicians to work out it's probably
going to be spared if that is a very
haha we have to check to his top
mathematician
that's our problem
but we have some ideas they for the
special case i would really we saw it
for one of the seller and the one by
weaves also
assuming that's execution fees
you know you're not the united states do
the same
asio march in the production cost
so the sad i can't be sub-standard the
solution approach is at this tender okay
what is leading up to one of the salazar
and locke pricing this is a t_v_ i want
to tell you
see that's
it has connections into this accident
near the prices that for me or
not for me or let me explain to you
what's going on right over there
icm
real options
istep two difference
between tool
cautions
five enough
financial options see right now
so the first farm road that you may not
realize that but for those of you who
saw define it
is actually the classical
black shorts
to what's this
probe of opposition says is that
so you cannot
price of a real option use of difference
of two options is actually more
it's a molar
than this
blacks shows more time for me
so this is a key insights into what we
discovered
sleeves voice the lord
so the first one is the s_ and
and that's our second from right over
there
except what the uh... what a sad i what
i want to do is they want to
prize
the options
exactly equal to the virus
marginal value of capacity
there is a very nice things to know the
optimal office pricing processes that
reads a supermarket
but that he is the sellers in the
priced exactly in the bios marginal
look evaluation of capacity that's why
so they're going to post a you know
exactly that sends out the bios to take
exactly that
the off the mark
yeah basil exactly hard okay
we think we get it out but i don't
believe as a proposition i put it out of
context yes
to be careful because it's a videotaped
again you know how do you want to add
that in addition to work on their sound
siddha
the aquamarine options and i think we
believe up
is going to be uh...
yeah deceptive is basically fees at the
maximum rates
such that they want to know that he was
too
mocking opportunity costs
so that's that
ideal behind at psalm so we have to be
able to formalize it i haven't had time
you know
because i was not prepared
included a stop
put this together yes they have a
cleaning solution right over there
so we had been the way do you know we
get the media
the media instrument falling out
okay this is the solution
to my home
already question is not what we have
to assume in this process is uh... you
know
durmitor brawny emotion
okay that's standard
we plugged into a specific process
to see whether we can solve it
so you can see that psalm so the first
one yes
the classiest
so what's the relationship
between the price of options
so versus the stock market price
there was facile
here is
is the same direction sarita firstly
absent direction
is the spot market price is potter
they all his daughter who's also i have
not seen to egypt
also against them
we're going to pay more holczer dot
that's all they do do regular
bias within
toothpaste increases they can also
decrease
know the price option so thats
into tears so that's no surprise over
there
the supplies is that
next to
was chiles up hearing aids
so the first place the volatility see
right here
so you see that's the volatility of the
for market increases
price i think we often zakhu decreases
this is very content into is different
than people think this is was a new year
when we price in the options
the second thing that's also surprising
as the time to delivery so you know this
is increases
price of the reality is also decreases
pay so this is uh... what's surprising
conti duty of
so again quite know what kind of a key
here you can up to plug in the plan
you cannot say
i know i just looks like i just learned
it's not a you find as i opened a text
book and i want to set up in to be
changes
forecasting c_n_n_ one works it would
have to show you what
you know for the civil cases you know
see you have obviously nothing up
surprises
so basically i think they want to have
happened obviously setup here at the
framework you know that's the first step
towards the implementing up all proposal
you know how do you know asking the
question who want to do it face
similar to jackie at one time
actually you know
to the larger than that
they're going to do it to get into a
fall
they know they didn't do it in a high
priority i went to that website that
what's happened
they may correct me if they're watching
a videotape out but i didn't want to us
and that would change up reported off on
due to other priority
went and won uh...
exchange also trying to stick to it
to after seven exchange okay
to regain trades
office contact phone memory chips you
know they make this innocent
explicit that you don't put it up you
know any reporter tom
but they didn't do it but
i don't know yet exactly sent
they behave have other priorities
but i think we need to softball this
problems before go ahead to treat
because it's different
they are also other forms i one minute
today they have business tornado i'll
get a path together in this country are
you
but they are perfectly borrowing
exactly
from financial trading
you deposit codec and then i would say
that i love your lodging call yeah
the the point i'm making here is the
handout its
steve metalitz new this year and we just
saw about missing the unity and said
okay
apologize trading of this error real
options people if you're going to do it
took a to me it's not surprising they
have a business phone
fall while but
so they'll fall
but i think we'll look into it
good
but you have smart people
that arrest accelerated out talk about
but the key point is this is the first
step in we have a feeling of framework
off
weed out we have this up on eighteen th
may dial tone
right now
i hope he has he won forums where are
you going to do it
yes uh... huh
yet it's all right
cake rallies
we have to soften
and analytical
position
that seems to be fun
i think you have some point and i think
question how many emphasizing team
so what we have here content blockage
his style
it is a small
contact optimize the army so he is uh...
basically use
you use in general that's enough
today i want to do business even with a
small
subset of suppliers to resolve it
so you see these concerns and the stock
market is full
because for market leaders in radio to
lincoln
colleville-sur-mer
do what we have this result
we are not trying to solve jeno
that's almost the same thing
force this issue
fits into
calm water
canadians
meet until last month
holding out hope it's not ideal
have exhibited as
from turned its act together
that the n_t_s_b_ coco hostile towards
the next time
videotape it
dividend
lululu uh...