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Alexander-Chen2019_Article_ModelRiskInRealOptionValuation.pdf (1.28 MB)

Model risk in real option valuation

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Version 2 2023-06-12, 09:07
Version 1 2023-06-09, 17:57
journal contribution
posted on 2023-06-12, 09:07 authored by Carol AlexanderCarol Alexander, Xi ChenXi Chen
We introduce a general decision-tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor’s risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylised facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs. And large projects can be more or less attractive than small projects (ceteris paribus) depending on the risk tolerance of the investor, how this changes with wealth, and the structure of costs to invest in the project.

History

Publication status

  • Published

File Version

  • Published version

Journal

Annals of Operations Research

ISSN

0254-5330

Publisher

Springer

Issue

1-2

Volume

299

Page range

1025-1056

Department affiliated with

  • Accounting and Finance Publications

Full text available

  • Yes

Peer reviewed?

  • Yes

Legacy Posted Date

2019-05-31

First Open Access (FOA) Date

2019-05-31

First Compliant Deposit (FCD) Date

2019-05-31

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