Pricing real options under the constant elasticity of variance diffusion

✍ Scribed by José Carlos Dias; João Pedro Vidal Nunes

• Publisher: John Wiley and Sons
• Year: 2011
• Tongue: English
• Weight: 149 KB
• Volume: 31
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.20468

✦ Synopsis

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