Real Options: A Survey

This survey paper provides an overview of real options, in particular the connection with financial options, valuation methods (analytical methods vs numerical methods based on simulation, lattice approximations to stochastic processes and finite-difference methods) and a wide array of application areas, from R&D to operations management to renewable energy project selection. 1 Real Options vs Financial Options Managers today must not only take decisions under high uncertainty in fast-changing environments, but think ahead to the decisions they might want to take in the future, such as expanding a plant, contracting capacity or purchasing real estate that had been leased, and ensure now that they will have the ability to take those decisions later. Those opportunities are known in the literature as real options due to their similarities with financial options on stocks as well as their application to tangible (real) assets. They have emerged as a significant tool in the decisionmaker’s toolkit; however, they are in many ways more complex than their financial counterparts. Indeed, while the specific decision that the option will allow if exercised is usually embedded in the definition of the option and is thus fairly straightforward to articulate, it is in general difficult to value real options accurately, for instance because – in contrast with stocks – the underlying asset is rarely traded on public stock exchanges. This makes it challenging to create a replicating portfolio, the price of which would be equal to the option’s fair value under the no-arbitrage principle. Another source of difficulty is that, while financial options are limited to the realm of finance, real options find applications in a vast array of domains, where the ∗Research Scientist, Amazon.com, Seattle WA, USA [email protected]. This work was done while the author was a doctoral student at Lehigh University and was not sponsored by Amazon. †Visiting Associate Professor, M.I.T. Sloan School of Management, Cambridge MA, USA [email protected].