Tuesday, October 9, 2012

Options and hedges for projects?

In the financial strategies domain, we hear about options and hedges all the time. But in projects?

Actually, the same ideas apply in projects, though often the words we use are different. So, take a look at this:

Options: applying this strategy, we make a small down payment now in order to have the choice (option) at some future time to do something we don't want to foreclose--or fully commit to--now. Usually the down payment is not refundable, a sunk cost as it were.

Option examples: we may want to keep certain options open in the supply chain; in resource assignments; in technology choices. So, we might put a down payment to reserve supplier capacity to be provided later; we might pay a SME for a minimum commitment with an option for more; we might fund a prototype on an untested technology, with choice to go forward

Hedges: Hedges are a bit different than options. We hedge when we buy or invest in a counter strategy to the baseline such that a risk in the hedge will offset the risk in the baseline; in the project situation, we may not care about unfavorable risks in the hedge, only the opportunity it provides for offsets. The nice thing about a hedge is that it is not necessarily a sunk cost; the hedge position may be refundable or liquifiable.

Hedge examples: if our project is multinational, then one obvious hedge is around currency and exchange rates. We might hedge on payments in dollars by accumulating offseting reserves in the offshore currency. Thus, we can pay invoices with the most advantageous currency.

In the technology business, especially software for safety critical systems, we hedge safety risks with investment in multiple independent solutions. If we can then use a combiner in a Delphi mode, we then hedge the risk of any single point failure. This strategy was used extensively in the shuttle safety critical systems.

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