Model risk in real option valuation

Alexander, Carol and Chen, Xi (2019) Model risk in real option valuation. Annals of Operations Research. ISSN 0254-5330

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Abstract

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.

Item Type: Article
Schools and Departments: School of Business, Management and Economics > Business and Management
Depositing User: Joy Blake
Date Deposited: 31 May 2019 14:19
Last Modified: 01 Jul 2019 13:46
URI: http://sro.sussex.ac.uk/id/eprint/84050

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