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Keep Your Options Open: Extreme Programming and the Economics of Flexibility

by Erdogmus, Hakan and Favaro, John (2002-12-31) permalink

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In the financial industry options are used as an insurance against uncertainties or risks, e.g. lossses. The article discusses how similar principles are used in agile approaches to hedge risks, e.g. technology risks. Extreme Programming is looked at as an ‘Options-Driven’ process. Starting with a simple discounted cash flow example, the article moves on to explaining the short comings of an approach that is based solely on a cash flow analysis. Instead the authors suggest applying option pricing models, including the famous Black-Scholes model, to Extreme Programming. In particular YAGNI, small investments, frequents releases are looked at in the new context. The article also includes a brief introduction into the necessary mathematical formulas, which in some cases are non-trivial.

Rating: 4.0 out of 5 (1 rating)
Source: G. Succi, M. Marchesi, L. Williams, D. Wells: Extreme Programming Perspectives, Addison-Wesley 2002
File Type: PDF
Owner: admin
Categories: Customer, Economics, Estimating, Extreme Programming, Metrics, Planning, Project Management, Tools
Updated: May 17, 2006

Comments

Comments admin (17 May 20:21)

Excellent starting point on how to use option pricing models for Extreme Programming, but also agile approaches in general. The same way as waterfall-like development approaches are increasingly replaced by more agile approaches, evaluation as to be improved as well. This article presents a promising starting point.

Assuming the authors are right, then software projects can be treated similar to trading with options and futures in the financial industry. This is not necessarily a very comfortable position to be in because of the associated risk.

If, however, the suggested approach clarifies the real nature of software projects then using the discussed techniques definitely helps improving decision making for software projects, in particular agile projects.

The biggest weakness of the article is from my perspective the assumption that the curve for cost-of-change is flattened with agile approaches. However, no data or facts are provided that support this statement. All conclusions presented are plausible. But as long as there is no evidence for the flattened cost curve a large proportion of the article is just an academic exercise with limited practical value.

Some minor issues I found: - The article assumes that the strike price is higher than the asset price. This is not always true. At the time of purchasing an option, it can already be ‘in the money’, meaning that the asset price is higher than the strike price. - Whether or not an option is considered for purchase depends also on whether a sufficiently large market exists for the option. How does the market for ‘real options’ look like in the case of software projects?