THE JOURNAL OF FINANCE • VOL. LXII, NO. 1 • FEBRUARY 2007 The Value of Embedded Real Options: Evidence from Consumer Automobile Lease Contracts CARMELO GIACCOTTO, GERSON M. GOLDBERG, and SHANTARAM P. HEGDE ∗ ABSTRACT Under the common assumption of constant interest rates, we show that penalties for early termination of a lease are often structured in such a way that the cancellation option embedded in consumer automotive leases has little value. Furthermore, our estimates drawn from a sample of three popular car models over 1990 to 2000 indicate that the stand-alone value of the lease-end purchase option is, on average, about 16% of the market value of underlying used vehicles, or about $1,462 per contract. Finally, we examine the sensitivity of our option value estimates to model parameters and default risk. RECENT YEARS HAVE WITNESSED A DRAMATIC GROWTH in the leasing of automobiles. For instance, overall industry sales data indicate that about a third of the new vehicles and trucks sold in the United States are leased (Hendel and Lizzeri (2002), and Miller (1995)), and the Federal Reserve Board survey of family finances reports that the use of leased vehicles by individuals (nonbusiness consumers) has risen from 2.9% to 5.8% over the 1992 to 2001 period (Azicorbe, Kennickell, and Moore (2003)). Consumer automobile lease contracts for new cars often include two embedded options that are not associated with a typical debt contract. The first is a cancellation option that allows the lessee to ter- minate the lease early. The second is a European call option, which gives the lessee the right, but not the obligation, to purchase the leased (used) vehicle at the scheduled termination of the lease at a predetermined exercise price. Both of these options are simple examples of real options because the asset under- lying these options is a used car, that is, a real asset; however, these options constitute a special case of real options since they are embedded in the lease contract, which is a financial (credit) instrument. Theoretical analyses of lease contracts show that the cancellation option is quite valuable (Schallheim and McConnell (1985)). With respect to the purchase option, Hendel and Lizzeri (2002) argue that they can play an important role in ∗ Giaccotto is at the University of Connecticut. Goldberg is at the Gabelli School of Business, Roger Williams University. Hegde is at the University of Connecticut. We thank the editor, Rob Stambaugh, an associate editor, an anonymous referee, John Harding, Jonathan Curran, and semi- nar participants at the University of Connecticut, the University of Massachusetts, Roger Williams University, and the 2003 Financial Management Association conference in Denver for many helpful comments. All remaining errors are our responsibility. 411