VICTORY!

We live in an uncertain world and this is a good thing. On the personal level, it keeps our attention as our lives pass by. And on the professional level, uncertainty provides opportunities for gain. Uncertainty is not synonymous with risk (please see Definitions). Hence, properly managed risk can expose a business enterprise to the upside potential inherent in uncertainty, while limiting exposure to the downside. As far as historians can tell, formalized risk management has been practiced in various forms for at least four centuries, but it wasn’t until 1973 that Fischer Black and Myron Scholes developed the now famous model for pricing options on equities. As with anything that works well, the Black-Scholes Options Pricing Model has been applied to problems that go beyond the original research. One of the most interesting applications is using the Black-Scholes model to price options on real (i.e. physical) assets, rather than financial assets, since real options represent the future value that companies might create by exploiting presently unknown, but not unanticipated, future opportunities. The buy low / sell high strategy pursued by every asset trader in shipping has heretofore been abstract, instinctual, “gut feel”. Now, Black-Scholes enables quantification of the payoff matrix and in the process, the rationale for making what often appear to be marginal investments in shipping is revealed. It is the embedded option to sell the ship into a rising market – a real call option, and shipping’s historic volatility that virtually assures some such opportunities will present themselves during a ship’s or project’s life span, that adds value. Significantly, via real options valuation, the very same Black-Scholes model that has contributed so much to development of the derivatives markets could now return the favor to the underlying shares. This is because contrary to a lot of popular wisdom, uncertainty actually adds value when the risks attached to it are correctly managed. The Black-Scholes model provides the means to measure such value; hence real options could become an important new tool for valuing a company’s portfolio of risky assets. The potential benefit to shipping is huge, since assets are costly, risky and often discounted by the market. This is best illustrated by an example.

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