Real Options: Added Returns Versus Added Risk

Risk in a firm is not just the variance of its accumulated net cash-flow with the unchanged allocation of that firm’s resources to its business. Multiple resource reallocation strategies, or real options, not only change a firm’s return but also alter that firm’s risk. This study has used formal models to explore how four popular real options (redeployment/switching, idling/shutting down, divestiture/abandonment, and growth/acquisition) change risk in a firm and has come to the following tentative conclusions. First, the presence of real options generally entails the tendency for a positive risk-return relationship in firms. Second, despite this general tendency, at least some options allow firms to receive high returns and low risk at once. Third, some option determinants have oppositely directed effects on risk and on return. Finally, some real options can reduce a firm’s risk, whereas other real options always increase that risk.