A Range-Based Finite Difference Approach to Valuing Options in Markov Switching Regimes* |
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Authors: | Nauzer J Balsara Andrea Vidozzi Luca Vidozzi |
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Institution: | 1. Associate Professor of Finance, Northeastern Illinois University , Chicago, Illinois, USA;2. Graduate Students in Applied Mathematics , Illinois Institute of Technology , Chicago, Illinois, USA |
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Abstract: | Recognizing the inflexibility inherent in standard capital budgeting analysis, recent research has provided new insights using a real options framework. This paper uses the explicit finite difference approach to value real options. However, instead of assuming a constant return and volatility term, we assume that these variables are sensitive to changes in the economic environment. Accordingly, we adapt our approach to incorporate a Markov switching feature. Further, we recognize that some of the modeling assumptions can be violated in a practical application. Therefore, we recommend using range based estimates of the real option value, as opposed to a point estimate. |
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