Pricing real options under the constant elasticity of variance diffusion |
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Authors: | José Carlos Dias João Pedro Vidal Nunes |
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Institution: | 1. Finance Research Center (FRC/ISCTE) and ISCAC Business School, Bencanta, Coimbra, Portugal;2. Finance Research Center (FRC/ISCTE) and ISCTE Business School, Complexo INDEG/ISCTE, Lisboa, Portugal |
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Abstract: | Much of the work on real options assumes that the underlying state variable follows a geometric Brownian motion with constant volatility. This paper uses a more general assumption for the state variable process that better captures the empirical regularities found in commodity markets. We use the constant elasticity of variance diffusion, where volatility is a function of underlying asset prices, and we provide analytic solutions for perpetual American options. We show that a firm that uses the standard lognormal assumption is exposed to significant errors of analysis, which may lead to nonoptimal investment and disinvestment decisions. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:230–250, 2011 |
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