In This Article Expand or collapse the "in this article" section Real Options Theory

  • Introduction
  • Early Empirical Evidence on Real Options
  • Special Issues of Academic Journals
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Management Real Options Theory
by
Lenos Trigeorgis
  • LAST REVIEWED: 27 October 2022
  • LAST MODIFIED: 27 October 2022
  • DOI: 10.1093/obo/9780199846740-0213

Introduction

Real options theory analyzes the value of managerial flexibility to adapt and revise future decisions to capitalize on favorable future investment opportunities or to limit downside losses from adverse market developments, which is vital to long-term corporate success in an uncertain and changing marketplace. Managerial flexibility manifests in terms of a set of corporate real options on whether to defer or stage investment, expand or grow, contract, abandon and switch use, or otherwise alter a capital commitment. Real options theory brings the theory of financial options from the capital markets to the realm of corporate investment decisions and strategic decision making under conditions of uncertainty. Real options are seen as opportunities (without an obligation) to acquire (dispose or reposition) real assets on possibly favorable terms. These terms depend on adjustment (or switching) costs, imperfect competition or other imperfections in product or factor markets. But whereas in the case of financial options the investor has the right to acquire (or sell) a financial asset (e.g., shares of stock) as the underlying security, in real options the underlying is a “real” asset whose expected future cash flows are linked to new product development via investing in an R&D program or the exploitation of a patent, the construction and subsequent scale up of a manufacturing plant in the home country, new foreign market entry and the growth or shifting of foreign subsidiary operations within the network of a multinational company (MNC), and so forth. Real options theory has thus extended options thinking (and methods) from the financial markets, where options are based on tradable contracts with specified terms, to real assets, tangible or intangible. Tangible or physical real assets underlying real options might include R&D and patents; land or real estate; natural resources, such as oil, gas, or mineral reserves; manufacturing plants; and strategic acquisitions; intangibles include brand and reputation, unique business processes, flexible human capital, and knowledge developed in joint ventures or other cooperative agreements.

The Nature and Domain of Real Options

A (real) option gives the right, but not the obligation, to take a specific future action (e.g., to invest) at a specified cost. The outcome of exercising the decision right is asymmetric as the decision maker can take the future action only if it is beneficial, but not otherwise. Certain rights may be established through contracts (e.g., options to acquire a JV partner’s stock, patents) or through specific knowledge obtained by the firm (e.g., through R&D or a strategic acquisition). The discretionary nature of option payoffs gives rise to an asymmetry in firm outcomes. In the case of a call option to invest (or defer investing), the firm can take advantage of upside opportunities (through exercising the call option, e.g., to invest or expand) while limiting downside losses (by not exercising the option in adverse market conditions). Due to this inherent preferential asymmetry, higher uncertainty in the underlying asset (investment project or firm value) or a broader range of possible future outcomes benefits the investor or holder of the option. Real options theory uses and extends the theory of financial options from the financial markets to the realm of strategic decision making by capitalizing on upside opportunities to acquire real assets on possibly favorable terms. But while for financial options an investor has the right to pay a set price (the exercise or strike price) within a given horizon (the option maturity) to acquire a financial asset (e.g., a company’s shares of stock), in real options the underlying asset is a “real” asset whose current value (the analogue to the stock’s current price) is estimated as the present discounted value of incremental cash flows resulting from the construction or expansion of a factory, the development of a new product via an R&D program or the commercialization of a patent, and so forth, by incurring a discretionary investment cost. Real options theory thus extends options thinking from the financial markets, where options are based on traded contracts with specified terms, to real assets, tangible or intangible, with potentially less clear terms. As a result, there are many different types of real options, such as the option to defer investment or stage product development, grow (e.g., enter a new or foreign market), alter the scale of production (i.e., expand or contract a manufacturing plant or an outsourcing agreement), switch inputs or outputs (e.g., switch among energy fuels or suppliers or switch production across an MNC’s foreign subsidiaries), abandon the investment or exit the market (e.g., sell the technology or assets for salvage), etc. Most firms manage a portfolio of such options within and across the different categories. Real-life decisions that firms make regarding the acquisition, upkeep, and exercise of these real options can affect the value of other options in the firm’s portfolio, and typically negative interactions due to functional redundancy need to be accounted for when making these decisions and accessing the value of the firm’s real options portfolio. The benefits from real options are often remote and difficult to predict (or secure), as in R&D. Multiple sources of uncertainty, exogenous (e.g., demand, labor costs, or exchange rates) or endogenous (partner or rival behavior) can affect their value. Unlike financial options, many real options may not be liquid or traded in market exchanges (occasionally they may not even yet exist, as in R&D); they may be asset or firm specific (and, hence, partly irreversible), which gives rise to challenges, such as information asymmetries and path dependence; and their terms (e.g., option maturity) may not always be clearly defined. Inasmuch as earlier firm activities and complementary investments shape future investment opportunities, an inter-temporal linkage between the firm’s past and future investment activities may be influenced by the firm’s prior resource endowments and adaptive or dynamic capabilities. Firms that have not made necessary pre-investments or are unable to envision how particular follow-on opportunities stem from prior investment activities may not have access to the same investment opportunity set on similar terms. In this sense, real options can lead to a competitive advantage by providing preferential and heterogeneous access to future investment opportunities. Some seminal contributions to the development of real options theory are discussed next.

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