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Valuing real options using implied binomial trees and commodity futures options

✍ Scribed by Tom Arnold; Timothy Falcon Crack; Adam Schwartz

Publisher
John Wiley and Sons
Year
2007
Tongue
English
Weight
324 KB
Volume
27
Category
Article
ISSN
0270-7314

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✦ Synopsis

Abstract

A real option on a commodity is valued using an implied binomial tree (IBT) calibrated using commodity futures options prices. Estimating an IBT in the absence of spot options (the norm for commodities) allows real option models to be calibrated for the first time to market‐implied probability distributions for commodity prices. In addition, the existence of long‐dated futures options means that good volatility estimates may now be incorporated into capital budgeting evaluations of real options projects with long planning horizons. An example is given using gold futures options and a real option to extract gold from a mine. A detailed out‐of‐sample test is included that shows how IBT option pricing errors evolve on subtrees emanating from future levels of the underlying asset. Β© 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:203–226, 2007

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