Real Option Definition

Advantages of real options


    Flexibility and robustness can be used to deal with future uncertainty. Real options analysis ROA provides a welfare-economics framework to design and evaluate robust and flexible FRM strategies under risk or uncertainty.

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    In this paper, we investigate benefits and limitations of a ROA, by applying it to a realistic FRM case study for an entire river branch. We illustrate how ROA identifies optimal short-term investments and values future options.

    We develop robust dike investment strategies and value the flexibility offered by additional room for the river measures. We benchmark the results of ROA against those of a standard cost-benefit analysis and show ROA's potential policy implications.

    A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. Real options differ thus from financial options contracts since they involve real i.

    The ROA for a realistic case requires a high level of geographical detail, a large ensemble of scenarios, and the inclusion of stakeholders' preferences. We found several limitations of applying the ROA. It is complex.

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    In particular, relevant sources of uncertainty need to be recognized, quantified, integrated, and discretized in scenarios, requiring subjective choices and expert judgment. Decision trees have to be generated and stakeholders' preferences have to be translated into decision rules.

    On basis of this study, we give general recommendations to use high discharge scenarios for the design of measures with high fixed costs and few alternatives.

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    Lower scenarios may be used when alternatives offer future flexibility. AB - Decisions on long-lived flood risk management FRM investments are advantages of real options because the future is uncertain. KW - adaptation.

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