Derivatives in IT decision making

Doesn’t topic look strange? Yes I am referring to using derivatives in selecting IT solution. I haven’t got crazy working in IT industry after MBA finance but the fact is it relates. I read an amazing article from an analyst of Forrestor who had proposed this concept and I have highest respect for his knowledge and conceptual clarity of both the worlds – IT and Finance. So the credit for this post goes to him. I am trying in this post to explain my understanding of the report in simple words for benefit of non-IT guys.

Let me start with simple question – what does a business looks for from its IT? I know it may mean different to different businesses but in very crude terms we can say that IT must at very basic level facilitate the business to grow and thereby achieve its objective. Now the question for CIO is when business looks forward to IT for some solution to business problems he needs to select best from variety of alternatives available. This is very subjective since it has to take into consideration variety of constraints like budget, available skill set and future business outlook. But do all the necessary factors are factored in while making such decision? How is the cost-benefit done for each option? More often than not CIO would determine cost of implementation and the value of direct benefits from it and then select one which gives maximum value for given cost which should be within the budget. But is this the best way to take such decision? I will give simple example. Given business problem say introducing online shopping can be solved by solution A and solution B. Cost of solution A is say Rs 1 lakh while of solution B say 1.2 lakh which provides same functionality but with flexibility to add auction feature within a year. Now given above method of decision making CIO would select solution A since there is no way to factor the value of limited (time bounded) flexibility that solution B offers. So here if CIO is able to find the value of flexibility then he can make better decision. Then how to find its value?

The answer to this problem is call option from finance industry. This case is similar to concept of the call option which gives the buyer of the option a right to buy the underlying at strike price before expiry date of the option. Here also solution B offers CIO a right to implement auction functionality at certain determined cost within a year. The call options have value for the right they provide and similarly this flexibility should also have value. Call options price is found using Black Scholes option pricing formula:-

c= s*f(d1) –xe-rt f(d2)
d1={log(s/x) + (r + v2 /2)t}/v*sqrt(t)
d2 = d1 – v*sqrt(t)

where ,
s= price of underlying
x= strike price
r= risk free rate of interest
t= time duration for expiration of option
v = volatility for stock
f= standard normal cumulative distribution function.

We can use same formula to find value of the flexibility to make more informed decision since the concept is same. In our case

c= value of the flexibility provided
s= return on implementation of auction feature
x = cost of implementation of auction feature
t = 1 year here i.e. time available to avail the flexibility
v= volatility of industry can be used to predict volatility of business and hence technology usage.

So using this above option we can find value of this flexibility and that value can be deducted from option B to make it comparable with option A. This would enable better decision making for CIO than obvious methods that are used today. Further it provides him an opportunity to deliberate on future features that might be required and may facilitate him to provide more objective explanation to CFO for budgetary approval of flexible IT solution that may help business in longer term.
I know you may question lot of assumption like that of volatility and usage of normal distribution and most important the assumption made by Black-Scholes in pricing model etc. But this post is meant to bring to your knowledge entire new dimension of using the financial knowledge in IT decision making. We can always debate out the viewpoint and criticize the shortcoming of any model but at same time I think we should appreciate the new perspective.