Model risk in real option valuation

Carol Alexander and Xi Chen
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Xi Chen: University of Sussex

Annals of Operations Research, 2021, vol. 299, issue 1, No 42, 1025-1056

Abstract: 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.

Keywords: CARA; CRRA; Certain equivalent; Decision tree; Divestment; Hyperbolic absolute risk aversion; Investment; Mean-reversion; Risk aversion; risk tolerance (search for similar items in EconPapers)
JEL-codes: C44 D81 G13 G30 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (3)

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Working Paper: Model Risk in Real Option Valuation (2018)
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DOI: 10.1007/s10479-019-03273-4

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