A Real Options Approach to Valuing a Multi-Year Procurement Contract

Using real options analysis we have developed a methodology to estimate the value of the revenue risk reduction that the government provides when it enters into a multi-year procurement (MYP) with a defense contractor. We apply methods used to price financial options to estimate the value of a notional MYP contract with a representative defense contractor. While the government often uses MYP contracts to buy weapon systems, it has not previously been compensated for reducing the revenue volatility of its contractors. We show that this reduction in volatility has substantial value to the contractor.