An analysis of the effects of risk biases on real options pricing

Over the past two decades, a significant amount of academic knowledge has been created on how to apply real options analysis to business investments. Despite the many apparent advantages of using real options to value projects, the approach has not found favor with managers in practice. Some critics claim that the method is untrustworthy and might encourage too much risk taking. This dissertation provides an exploration of risk biases, viewed through the lens of prospect theory, as a potential cause for the mistrust toward real options. Using evidence from a survey of 67 business school students, the results showed that participants generally evaluated options in a manner consistent with prospect theory’s S-shaped utility function. This research agrees with prior findings that buyers will price options at a discount and adds to the literature by confirming a new hypotheses that call options are consistently discounted more than put options of similar expected value. Additionally, evidence is provided that, in agreement with prospect theory, small probabilities cause distortions in options pricing. In general, pricing biases were found to be dependent on the framing of the scenario as either a gain or a loss and whether or not there were small probabilities involved. These findings bring into question the applicability of standard risk measures, such as discount rates derived from opportunity costs, to options scenarios.