Corporate risk management: Real options and financial hedging

Abstract

Financial derivatives are now widely used by corporations to tailor exposure to currency, interest rate, and commodity price risks. However, risk management within the firm can be, and in some cases must be, accomplished through alternative means, including investment in and optimal exercise of the firm's real options. Real options are opportunities to delay and adjust investment and operating decisions over time in response to the resolution of uncertainty. Real options not only protect a firm from the adverse consequences of excess risk exposure, they also provide opportunities for firms to exploit uncertainty. A firm that is able to take advantage of its real options, and concurrently use financial contracts to transfer and control any residual risk, can fully realize the value enhancing benefits of an integrated risk management strategy.