Article2010

Pricing real options under the constant elasticity of variance diffusion

José Carlos Dias · João Pedro Vidal Nunes

37 citations0/0 files storedJournal of Futures Markets

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Capital Investment and Risk Analysis Financial Markets and Investment Strategies Stochastic processes and financial applications

Abstract

Abstract Much of the work on real options assumes that the underlying state variable follows a geometric Brownian motion with constant volatility. This paper uses a more general assumption for the state variable process that better captures the empirical regularities found in commodity markets. We use the constant elasticity of variance diffusion, where volatility is a function of underlying asset prices, and we provide analytic solutions for perpetual American options. We show that a firm that uses the standard lognormal assumption is exposed to significant errors of analysis, which may lead to nonoptimal investment and disinvestment decisions. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:230–250, 2011

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References

1973The Pricing of Options and Corporate Liabilities 1994Investment under Uncertainty 1973Theory of Rational Option Pricing 2005Theory of rational option pricing 1982The Value of Waiting to Invest 1976The valuation of options for alternative stochastic processes 1985Evaluating Natural Resource Investments 1989Entry and Exit Decisions under Uncertainty

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