Valuing real options with endogenous payoff

Abstract

This study investigates irreversible investment decisions when the exercise payoff is scale-dependent; thus, it is endogenously determined by the firm's risk management. We find that the scale-dependency gives rise to a speculative risk management strategy: a positive relationship between the firm's derivatives position and unhedged cash flow. Moreover, investment can be hastened or delayed as the underlying uncertainty increases depending on the economic conditions due to the speculative strategy. The main force driving these results, different from those known in the existing literature, is that the firm's risk management is designed to optimize the risk-return trade-off of the endogenous payoff.