Title

Active Management of Real Options

Department

Economics, Finance, & Quantitative Analysis

Document Type

Article

Publication Date

2011

Abstract

Business opportunities to introduce new products at a later date are treated as real options. These real options are modeled as exchange options for which both the underlying and strike assets are risky. The distance to breakeven for an exchange option measures how far a real option is currently expected to be from having a net present value of zero on its expiration date. Because the underlying and strike assets are risky, the distance to breakeven and the value of the real option change randomly during the option's life. The distance to breakeven and the value of the business opportunity may be actively managed during the real option's life. Product design and process design may be used to change the values of the underlying and strike assets while the firm is waiting to introduce the new product. A case study shows that the distance to breakeven is an important measure for a business opportunity, active management can create substantial positive incremental value for good and marginal opportunities, and active management should not be used for bad opportunities.