Government Procurement in The United States - Reals Options Analysis

Reals Options Analysis

An recent approach to analysing Government procurements of large systems, such as weapons systems, is to use Real options analysis. Such procurements can be done in single annual lots (that is "single-year procurements," (SYPs)), however, it is also possible for the government to enter into multi-year procurement (MYP) contracts with Congressional approval. MYPs represent lower risk for the contractor in question, and thus should involve lower unit prices for the government. One way to look at this situation is that an MYP contract contains a real option allowing the contractor a choice to abandon the uncertainty associated with relying on sequential SYP contracts (analogous to a put option). Real options analysis thus allows the government to estimate the contractor's value of transferring revenue risk to the government as a function of the size of the contract and the volatility of the contract's value. An additional consideraion here is that, since the option is not actively traded, the ultimate negotiated price could be heavily influenced by the government and contractor attitudes towards risk.