Valuing Pilot Project Investments in Incomplete Markets: A Compound Option Approach

Eymen Errais () and Jeffrey Sadowsky
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Eymen Errais: Managment Science and Engineering Stanford University

No 73, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: We introduce a general framework to value pilot project investments under the presence of both, market and technical uncertainty. The model generalizes different settings introduced previously in the literature. By distinguishing between the pilot and the commercial stages of the project we are able to frame the problem as a compound perpetual Bermudan option. We work on an incomplete market setting where market uncertainty is spanned by tradable assets and technical uncertainty is private to the firm. The value of these investment opportunities as well as the optimal exercise problem are solved by approximate dynamic programming techniques. We prove the convergence of our algorithm and derive a theoretical bound on how the errors compound as the number of stages of the compound option is increased. Furthermore, we show some numerical results and provide an economic interpretation of the model dynamics

Keywords: real options; dynamic programming; incomplete markets (search for similar items in EconPapers)
JEL-codes: C6 G12 (search for similar items in EconPapers)
Date: 2005-11-11
New Economics Papers: this item is included in nep-fin
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