Chapter 4 - Use of Real Options as a Policy-Analysis Tool

Abstract

There are many different ways to assess the financial implications of risk. The suitability of different approaches depends on the type of decision being analyzed, who is making that decision, and the context in which the decision is being made. This chapter focuses mainly on portfolio theory, but also discusses other approaches, including the real options analysis. In both portfolio theory and real options theory, risk is characterized as a variance in returns from a particular asset. Portfolio theory is concerned with minimizing risk for a given return (or maximizing return for a given risk) through combining assets with different risk characteristics into a diversified portfolio, whereas real options theory is concerned with optimizing investments in the face of uncertain future states of the world taking account of managerial flexibility in decision making. This general equilibrium model is provided by the capital asset pricing model (CAPM), which provides an overarching theory of the pricing of risk in a perfect market under equilibrium. The key principle of portfolio theory is that when considering the acquisition of a new asset, the relevant risk to be considered is not the absolute variance of that asset's returns, but its contribution to the portfolio's total variance.