VALUING REAL OPTIONS: CAN RISK‐ADJUSTED DISCOUNTING BE MADE TO WORK?

Abstract

This paper examines three alternative approaches to valuing real options: (1) the standard option pricing technique using “risk‐neutral” probabilities; (2) the use of risk‐adjusted discount rates; and (3) discounting certainty‐equivalent values with a riskless discount rate. As suggested by the title, a question of particular interest is whether an approach based on risk‐adjusted discount rates can be “made to work” for valuing options. The answer is yes. Indeed, the authors show that any of the three approaches will provide a correct valuation if properly employed. Nevertheless, there are important differences in the information requirements associated with each of the three methods. Another important issue is the relative degree of difficulty in calculating the correct option value. When these two considerations are taken into account, the risk‐neutral option pricing procedure generally proves to be the preferred method. It tends to be computationally more convenient—often much more convenient—and to require less information than either the risk‐adjusted discounting or certainty‐equivalent procedures.

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