Modelling conversion options with a mean reversion motion

Carlos L. Bastian-Pinto () and Luiz E. T. Brandão ()
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Carlos L. Bastian-Pinto: PUC-Rio, IAG
Luiz E. T. Brandão: PUC-Rio, IAG

Brazilian Review of Finance, 2007, vol. 5, issue 2, 97-124

Abstract: Commodity prices are generally better modeled by a long-term Mean Reverting Process, than by a Geometric Brownian Motion stochastic diffusion process, which is more generally used to value real options, since it is simpler to use. In this article we model two correlated uncertain variables using a mean reversing process bivariate lattice to value the switch option between outputs available to ethanol and sugar producers, using the same source: sugarcane. The model results show that the switch option adds a signi cant value for the producer income. The article also shows that when modeled by a geometric brownian motion, the switch option yields significantly higher values than with a mean reverting model, for the option itself as much as for the base case without flexibility. This confirms that the stochastic model chosen can influence significantly the option value.

Keywords: real options; mean reverting model; switch options; commodity prices (search for similar items in EconPapers)
JEL-codes: C34 M21 Q42 (search for similar items in EconPapers)
Date: 2007
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