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Risk-adjusted Valuation of the Real Option to Invest

Author

Listed:
  • Carol Alexander

    (School of Business, Management and Economics, University of Sussex)

  • Xi Chen

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

Abstract

This paper resolves the conceptual ambiguity of real option value and derives a model using risk-adjusted discount rates that can be applied to value the option to invest in a project. The approach adopts stochastic revenue and costs which provide a general solution with the added virtue of applicability. We found the option value arises from the difference between an indi- vidual investor and the market in financing efficiency and risk preferences. Investors taking on idiosyncratic risks are crucial to obtaining the real option value; hedging project risks can significantly reduce the associated real option value.

Suggested Citation

  • Carol Alexander & Xi Chen, 2014. "Risk-adjusted Valuation of the Real Option to Invest," ICMA Centre Discussion Papers in Finance icma-dp2014-19, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2014-19
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    File URL: http://www.icmacentre.ac.uk/images/2014/12/ICM-2014-19.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    real option; decision making; investment opportunity; geometric Brownian motion; option to invest; discounted cash flow; change of measure; risk tolerance; risk aversion; idiosyncratic risk; gold mine;
    All these keywords.

    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
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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