This article is from the archives of the UB Reporter.

Real options theory focus of research by SOM professor

Published: August 25, 2005

Reporter Contributor

The science of real options, a new way for large corporations to structure and manage their strategic investments under uncertain business conditions, is the focus of research by Wenfeng "Tony" Tong, assistant professor in the Department of Management Science and Systems in the School of Management.


Tony Tong studies real options theory, a new way for large corporations to structure and manage their strategic investments in uncertain business environments.
PHOTO: Nancy J. Parisi

Tong, who is completing his first year on the UB faculty, explains that when an investor purchases an option in uncertain environments, the investor cannot lose any more money than the cost of the option. However, the amount of money he or she stands to make—should the uncertainty be resolved favorably and thus the option be exercised—is potentially much larger.

Real options theory emphasizes the value of managerial flexibility and the importance of follow-up on investment opportunities, specifically in regard to companies making decisions on how to invest in new products or geographic markets, particularly in uncertain settings, Tong notes.

If executed successfully, the theory can help companies make investments that have the potential to make more money than they lose-in other words, the greatest possible return is higher than the greatest possible loss, and this asymmetric payoff structure captures the essence of real options.

Option theory, Tong points out, was originated in the finance field, but has practical implications in the business world, especially when it comes to investing internationally.

When there's huge uncertainty in a business environment, a company usually should hold its investment decisions until the uncertainty is resolved, Tong says. But if valuable growth opportunities also come in those situations, it may make sense to make early investments, he adds.

Tong cites as an example U.S. firms' entry into the rapidly growing-but unpredictable-Chinese and Indian economies. He says, a U.S. firm may not want to make a full commitment in those markets, but it may not want to pass up potentially lucrative investment opportunities, either. In these cases, the U.S. firm can consider investing in a joint venture in those countries, as the venture provides a real option for the firm in the sense that the initial investment is relatively small, yet it positions the firm to expand should uncertainty be resolved favorably.

Tong also studies the performance of firms that have made strategic investments, based on option theory. For example, he says a multinational firm can decide where to produce its products by shifting its value-chain activities, based on changes in labor costs, tariffs, exchange rates and other factors. In option terms, a multinational firm has a real option that allows it to operate flexibly by conducting multinational manufacturing, and it stands to benefit from uncertain conditions, such as volatile exchange rates, Tong adds.

Thus, one would assume that multinational firms would have an advantage over domestic firms because they have choices domestic firms don't have. However, that's only true up to a point, he says.

"My study shows that U.S. multinational firms indeed are able to enjoy certain benefits in the form of downsized risk reduction," he says. But when a firm gets too large—which in his research means operating in more than 10 countries—the costs of coordinating such a complex system tend to get in the way of the benefits generated by having all those potential choices. Thus, the risk-reduction benefits tend to level off, he notes, when a company gets too large and expands beyond a certain number of countries.

A native of China, where he received a bachelor's degree in economics from Shanghai Institute of Foreign Trade before going to the National University of Singapore for a master's degree, Tong moved to the United States to pursue his doctorate at The Ohio State University. When he began looking for academic jobs after finishing his doctorate, he wanted to work at a research-oriented institution, preferably near the East or West coasts.

"I think Buffalo is a very research-oriented school," he says. "And people in my department are very supportive."

Tong says the management school has allowed him to fulfill all of his teaching requirements during the spring semester, freeing up the fall semester for his research. This past spring, he taught a senior capstone course and was, overall, impressed with his students' knowledge and the quality of their work and insights.

"As undergraduates, they have very broad knowledge," he says, noting that students who had done internships and had work experience seemed especially well-prepared for his class.

The best students, he says, can see outside their own area of expertise. "Students need to develop a firm-wide perspective on how to manage a firm to achieve a sustained competitive advantage," he adds.

Tong points out that another reason he chose UB was the school's name recognition in China.

"UB's School of Management was one of the first business schools that moved into China back in the 1980s to establish joint business-degree programs with Chinese universities," he says, referring to the MBA program established at the National Center for Industrial Science and Technology Management Development in Dalian. "It has a very good reputation in China and that means much to me."

Tong lives with his wife and two young children in an apartment close to campus, which, he says, is ideal not just for commuting, but for his 4-year-old daughter to attend preschool. She attended the preschool program of the Early Childhood Research Center in the Graduate School of Education last year and had a wonderful experience, he says.