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Real options valuation example
Real options valuation example









real options valuation example

To our knowledge this is the first study of model risk associated with these factors, some of which have not even been considered before. We also allow general assumptions about: the market price of the project the investment costs the frequency of exercise opportunities the size of the project relative to the decision-maker’s wealth the decision maker’s utility function and how her risk tolerance changes with wealth. To this end, we provide comparative statics of real option values with respect to the risk tolerance parameters of Hyperbolic Absolute Risk Aversion (HARA) utility. Our general framework allows one to quantify how much value is lost by a board with such a manager. For example, suppose the project is owned by a firm whose board would wish to apply risk-neutral valuation, but the decision-maker is a manager who uses her personal preference function. This paper develops a general model for real option valuation-with a utility which encompasses all the standard utility functions and with a price process which has the standard geometric Brownian as a special case-then, by setting specific values for model parameters, we can assess the change in real option value arising from different decisions.

real options valuation example

Here the term ‘model risk’ refers to the real-option value lost from making a ‘wrong’ decision, where the wrong decision is captured because we use inappropriate parameters in the model. Instead of following the main strand of the real options literature, which adapts and extends the mathematical models to more closely reflect the real-world characteristics of a particular investment opportunity, we shall drill-down into the real option model itself to examine the model risk inherent in the assumptions that are made for the decision. However, our paper addresses a much more fundamental issue.

real options valuation example

Much recent literature on investment real option analysis attempts to augment this basic model in various ways, to add special features that address particular practical problems. exercise the option) may be implemented at any time up to the investment horizon. the option strike), where all risks can be hedged so that risk-neutral valuation (RNV) applies, and that decisions to invest or divest (i.e. The basic model for analysing investment real options assumes that the project value follows a geometric Brownian motion (GBM) over a finite investment horizon, with a fixed or pre-determined investment cost (i.e. In this setting, ROVs merely allow the subjective ranking of opportunities to invest in alternative projects. So, unlike the premium on a financial option, the ROV has no absolute accounting value. The ROV represents the certain dollar amount, net of financing costs, that the decision maker should receive to obtain the same utility as the (risky) investment in the project. the investor) and it will depend on her attitude to risk. The real option value (ROV) is the value of this decision opportunity to buy or sell the project it is specific to the decision maker (i.e. Footnote 1 Similarly, we identify the option strike with the investment cost for the project and in the following we shall use these two terms synonymously. Any higher price would exceed her value and she would not buy the project any lower price would induce her to certainly buy the project. Following Kasanen and Trigeorgis ( 1995), we identify the project value with a market price that is the ‘break-even’ price for which a representative decision maker would be indifferent between buying or not buying the project. The term ‘investment’ real option concerns the opportunity to buy or sell a project (such as a property-real estate, a company, a patent etc.) or a production process (such as an energy plant, or pharmaceutical research and development). It is a right, rather than an obligation, whose value is contingent on the uncertain price(s) of some underlying asset(s) and the costs incurred by exercising the option. The original definition of a real option, first stated by Myers ( 1977), is a decision opportunity for a corporation or an individual.











Real options valuation example