Multi-stage real option evaluation with double barrier under stochastic volatility and interest rate

Michele Bufalo (), Antonio Di Bari () and Giovanni Villani ()
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Michele Bufalo: Territory and Finance Università degli Studi di Roma “La Sapienza”
Antonio Di Bari: University of Bari
Giovanni Villani: University of Bari

Annals of Finance, 2022, vol. 18, issue 2, No 4, 247-266

Abstract: Abstract This paper focuses on valuing R&D projects using a twofold compound real option by including two knock-out barriers. However, the valuation of R&D projects is not a simple task, since they are characterised by various risks and sequential decision-making. Specifically, we embed a double-barrier in the multi-stage real option in order to mitigate the risk of huge losses for the investor. In this way, our model incorporates the opportunity to abandon a project if its profitability falls below a benchmark level. We contribute to the existing literature in these ways: first we present a closed formula that allows evaluating this kind of project assuming the technical uncertainty of each research phase; secondly, we consider the scenario in which the volatility and the interest rate are both stochastic. Finally, we provide an application for a wind farm case.

Keywords: Down-and-out barrier option; Compound real options approach; Wind farm projects (search for similar items in EconPapers)
JEL-codes: G12 G31 K32 O30 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s10436-021-00403-6

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