Alternative Approaches for Solving Real-Options Problems

James E. Smith ()
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James E. Smith: Fuqua School of Business, Duke University, Box 90120, Durham, North Carolina 27708-0120

Decision Analysis, 2005, vol. 2, issue 2, 89-102

Abstract: Brandao et al. (2005) describe an approach for using traditional decision analysis tools to solve real-option valuation problems. Their approach calls for a mix of discounted cash flow analysis and risk-neutral valuation methods and is implemented using Monte Carlo simulation and binomial decision trees. In this note, I critique their approach and discuss some alternative approaches for solving these kinds of problems. My criticisms and suggestions concern implementation issues as well as more fundamental issues. On implementation, I discuss the use of binomial lattices instead of trees, and alternative methods for estimating volatilities. More fundamentally, I discuss alternative approaches that rely entirely on risk-neutral valuation and model the uncertainties in the problem more directly.

Keywords: decision analysis; real options; decision trees; binary approximations (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (52)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ordeca:v:2:y:2005:i:2:p:89-102

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