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A General Approach to Real Option Valuation with Applications to Real Estate Investments

Author

Listed:
  • Carol Alexander

    (ICMA Centre, Henley Business School, University of Reading)

  • Xi Chen

    (ICMA Centre, Henley Business School, University of Reading)

Abstract

We model investment opportunities with a single source of uncertainty, i.e. the market price of the investment. Investment cost can be predetermined or perfectly correlated with the market price. The common paradigm for risk-neutral real-option pricing is a special case en- compassed within our general framework, and we analyse the relationship between standard real option prices and the more general risk-averse real option values. Numerical examples illustrate how these general values depend on the frequency of decision opportunities, the investor's risk tolerance and its sensitivity to wealth, his expected return and volatility of the underlying asset, and the price of the asset relative to initial wealth. Specific applications to real estate include property investment under 'boom-bust' or mean-reverting price scenarios, and buy-to-let or land-development opportunities.

Suggested Citation

  • Carol Alexander & Xi Chen, 2012. "A General Approach to Real Option Valuation with Applications to Real Estate Investments," ICMA Centre Discussion Papers in Finance icma-dp2012-04, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2012-04
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    File URL: http://www.icmacentre.ac.uk/files/discussion-papers/DP2012-04.pdf
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • C44 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Operations Research; Statistical Decision Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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