Modifying Real Options’ Probability of Exercise

A critical difference between real options and financial options lies in that real option holders, writers, and even external stakeholders can modify the characteristics of real options. Furthermore, exercising a real option can have repercussions onto multiple stakeholders. To modify the exercise probability of real options, one may adjust the strike price, or the level and uncertainty of the underlying process. For example, a government can provide land to an investor such as a manufacturer, a power producer, and a university. This would result into a reduction of the strike of a real call option and an increase in the probability of exercise. Another modification could be to offer future tax credits. This would result into an increase in the present value of the future cash flows and an increase in the probability of exercise. This paper proposes general model-free conditions under which a modification of real options qualitatively increases or decreases the physical exercise probability of real options. We find an analytic solution to the effect of variance change on the probability of exercise. In the second part of the paper, to quantify the exercise probabilities, we propose a general computational framework using the Least-Squares Monte Carlo method for American-style real options. Findings show that an incentive required to promote the exercise of an American-style option before or at maturity is less than that for a European. The paper provides various numerical examples to show that using our framework, a stakeholder, who desires to increase or decrease the exercise probability, may find an optimally parsimonious way of modifying the underlying process or the strike. JEL classification: G12, G31, G32