Real options: Added return versus added risk

A key benefit of real options is that they provide a firm with an additional return, above the expected discounted net cash flow that the firm would receive from the indiscriminate use of its resources. Some research on strategic resource allocation informally speculated that, along with providing a firm with an extra return, real options can help that firm reduce its risk. The empirical corroboration of the availability of such dual benefits for firms has been limited because that idea was never carefully developed theoretically. This study develops formal models that demonstrate how four popular real options affect a firm’s risk. With a few qualifications, a firm’s risk is shown to be increased by real options. In addition to explaining this more-general result and the exceptions leading to risk-reduction, this study develops a systematic account of how risk associated with real options derives from their determinants. • Most generally, real options increase risk for a firm holding them, just as they increase that firm’s return. • The first exception to that general result is that the firm’s risk is reduced by the presence of the abandonment option. • The second exception is that the firm’s risk is reduced by the option to alter the firm’s operating scale. • The third exception is that risk is cut by the switching option if the destination has less random cash flow than the origin.