Computer Science Department
School of Computer Science, Carnegie Mellon University


The Options Approach to Software Prototyping Decisions

Prasad Chalasani, Somesh Jha, Kevin Sullivan

July 1997

Keywords: Software engineering, economics, prototyping, real options, sequential investing, financial options

Prototyping is often used to predict, or reduce the uncertainty over, the future profitability of a software design choice. Boehm [Boehm84] pioneered the use of techniques from statistical decision theory to provide a basis for making prototyping decisions. However his approach does not apply to situations where the software engineer has the flexibility of waiting for more information before making a prototyping decision. Also, his framework considers only uncertainty over one time period, and assumes a design-choice must be made immediately after prototyping. We propose a more general multi-period approach that takes into account the flexibility of being able to postpone the prototyping and design decisions. In particular, we argue that this flexibility is analogous to the flexibility of exercise of certain financial instruments called options, and that the value of the flexibility is the value of the corresponding financial option. The field of real option theory in finance provides a rigorous framework to analyze the optimal exercise of such options, and this can be applied to the prototyping decision problem. Our approach integrates the timing of prototype decisions and design decisions within a single framework.

23 pages

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