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

Author

Listed:
  • Michele Bufalo

    (Territory and Finance Università degli Studi di Roma “La Sapienza”)

  • Antonio Di Bari

    (University of Bari)

  • Giovanni Villani

    (University of Bari)

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.

Suggested Citation

  • Michele Bufalo & Antonio Di Bari & Giovanni Villani, 2022. "Multi-stage real option evaluation with double barrier under stochastic volatility and interest rate," Annals of Finance, Springer, vol. 18(2), pages 247-266, June.
    • Handle: RePEc:kap:annfin:v:18:y:2022:i:2:d:10.1007_s10436-021-00403-6
    DOI: 10.1007/s10436-021-00403-6
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    Cited by:

    1. Michele Bufalo & Antonio Di Bari & Giovanni Villani, 2023. "A Compound Up-and-In Call like Option for Wind Projects Pricing," Risks, MDPI, vol. 11(5), pages 1-13, May.
    2. Guglielmo D’Amico & Shakti Singh & Dharmaraja Selvamuthu, 2023. "Analysis of fair fee in guaranteed lifelong withdrawal and Markovian health benefits," Annals of Finance, Springer, vol. 19(3), pages 383-400, September.

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    More about this item

    Keywords

    Down-and-out barrier option; Compound real options approach; Wind farm projects;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • K32 - Law and Economics - - Other Substantive Areas of Law - - - Energy, Environmental, Health, and Safety Law
    • O30 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - General

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