Real Options for Managing Risk: Using Simulation to Characterize Gain in Value
by
Gordon Sick
University of Calgary and Netherlands Institute of Advanced Study
Coauthors: Dan Calistrate (Department of Mathematics, University of Calgary), Marc Paulhus (Department of Mathematics, University of Calgary)

This paper explores real options methodology as a risk management tool. Instead of characterizing the value of a real option to an organization as some potentially unrealizable notional market value, it characterizes the real option as a tool for mitigating downside risk while allowing most of the upside potential of a project to flow through to its owner. We do this by simulating the value generated by a real option strategy and comparing it to the alternative strategies of immediate development (based on the NPV rule) and delay as long as possible (generating a european call option).

We compare the cumulative distributions of simulated value for the five strategies (including optimally managed development and abandonment real options) and compare them by means of total dominance, and second degree stochastic dominance. Optimally managed real options do not totally dominate, nor do they always dominate the other two strategies in the second degree. However, the analyst can examine the graphs of the cumulative distributions to see what sort of risk-averse utility function would be needed to justify a preference of one of the alternatives to a real option strategy.

The simulations are performed both for a risk-neutral distribution and for a risk-averse distribution. The distributions differ from each other by a risk premium in the drift of underlying asset value. Strictly speaking, stochastic dominance analysis should be performed on the true (risk-averse) distribution, rather than the risk-neutral distribution. Thus, dominance analysis performed on the risk-neutral distribution implicitly assumes there is no risk premium.

http://www.math.ucalgary.ca/~sick/gordon/SimulateReal.pdf

Date received: March 1, 1999

Copyright © 1999 by the author(s). The author(s) of this document and the organizers of the conference have granted their consent to include this abstract in Atlas Conferences Inc. Document # cacq-19.