Real Options in Service Investments: Scenarios from Defence

Abstract

This paper addresses the theme of investment under uncertainty in services. We specifically apply principles of contingent-claims analysis to underline the value of flexibility, i.e., the real options, embedded in service level agreements (SLAs) and maintenance & repair investments in the context of aerospace and defence. We focus on path-dependent and complex contingent-claims, to show how the design of 'exotic' type options in service investments can provide valuable insurance policies against operational and financial risks for the customer, in addition to enhancing providers' incentives from superior service performance. For illustration, we highlight examples of barrier, lookback, compound, chooser and extendible options as flexibility clauses/alternatives for service provision in defence contracts.