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Evaluating the occurrence and disappearance of real options

Author

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  • Michi Nishihara

    (Graduate School of Economics, Osaka University)

Abstract

This paper investigates the decision-making of a firm that has an option to invest in a single project among multiple alternatives. This type of option is called a maxoption, and the nature of a max-option has been investigated in several papers. I extend the previous analysis to a model that allows the random occurrence and disappearance of alternative projects in which to invest. The occurrence and disappearance of opportunities in which to invest will be caused by changes in regulation, the exit and entry of rival firms, technological innovation, political risk, catastrophes, etc. For example, the model applies to land development with an alternative land use choice under uncertainty about changes in zoning and development regulations. I show the properties of the exercise region and the value function for the option. Specifically, I demonstrate that the prospective future occurrence of an alternative has the significant effect of increasing the option value and deferring the investment decision.

Suggested Citation

  • Michi Nishihara, 2010. "Evaluating the occurrence and disappearance of real options," Discussion Papers in Economics and Business 10-19, Osaka University, Graduate School of Economics.
    • Handle: RePEc:osk:wpaper:1019
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    File URL: http://www2.econ.osaka-u.ac.jp/library/global/dp/1019.pdf
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    More about this item

    Keywords

    real option; max-option; exercise region; regulatory risk; Poisson arrival.;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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