Question

Question 2

Using real options in a risk environment can be beneficial if the enterprise need to make decisions on switching or acquiring multiple suppliers. Ericsson and Nokia had different approaches in managing risk, which led to different outcomes during a business interruption event at a major supplier.

a. Explain the difference between risk and uncertainty.

b. Explain how real options how can be used to inform decisions to reduce the impact of exogenous shocks on the enterprise.

Answer 1

a)

Risk and Uncertainty

Uncertainty refers to the lack of certainty of the happening of an event, In financial terms uncertainty is different from risk in the sense that the outcome can either be positive or be negative i,e the probability of happening of the events is not known.

On the other hand risk refers to probability of having a positive or a negative outcome. In risk after a careful consideration of the circumstances and given factors we arrive at a probability of happening of a positive or a negative outcome.

In layman's language risk refers to only the probability of a negative outcome but in finance, more risk can sometimes leads to high returns or even losses that can make an investor bankrupt.

The major difference between risk and uncertainty is that in risk the probability of profit or loss under different circumstances can be calculated in advance on the other hand for uncertainty the probability of occurrence of any outcome can not be determined with precision.

b)

Real options refer to the projects that include the investment in the tangible assets and not in just the financial instruments. Unlike options, real options are the choices to be made to make investment in different possible projects say, for expansion plans or for even for installation of machinery or any decision that relates to the blockage of funds for a long term. The management looks into the pros and cons of various options for real options and then decide on the basis of opportunity cost and returns of the said projects,

The real options provide a company with better shock protection, because once the funds are blocked in the real options its difficult to withdraw those funds and hence a carefully investment in a real option will help a company to cope up with exogenous shocks.