The Evolution of Real Options and its Applications in Management: A Review of Literature

Abstract

Real options evolve from options pricing theory (OPT), a very unique and widely applicable theory that traces its origin to the study of derivatives. Options, unlike the other financial derivatives, have unique risk management features that allow investors in financial assets to minimize their downside losses while they benefit maximally from upside potentials. An option gives the holder the right to a flexible investment decision in a later period. With the landmark derivation of option pricing formula in 1973, OPT has not only been successfully applied in other areas of finance but has also been extended to other disciplines in management. Real options, arguably the leading extension of OPT; apply the options theory to the appraisals of capital investment projects. This paper traces the evolution of real options to financial options and the study of derivatives. It reviews the study of derivatives and the evolution of options as derivatives with unique risk management characteristics. The review further covers the literature on applications of OPT in finance and the eventual evolution of real options. The paper then reviews real options and its applications in diverse disciplines of business and management. From the wide applications of real options' thinking and tools as revealed in the literature, the paper shows that real options have a great potential in offering plausible explanations to existing relationships in management including strategic management and in discovering new theories that will transform the field of management.