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Real option value and random jumps: application of a simulation model

[journal article]

Alonso-Bonis, Susana; Azofra-Palenzuela, Valentin; Fuente-Herrero, Gabriel de la

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Please use the following Persistent Identifier (PID) to cite this document:http://nbn-resolving.de/urn:nbn:de:0168-ssoar-241817

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Abstract This paper studies how sensitive real option valuations are to incorrect assumptions about the stochastic process followed by the state variables. We design a valuation model which combines Monte Carlo simulation and dynamic programming and provides an appropriate framework to evaluate the effect of estimation errors on both the value of real options and their critical frontier. Although the model is flexible enough to value American-type options contingent on a wide range of stochastic processes, we focus on the analysis of the effect of stochastic jumps. We apply our model to the valuation of an investment in the car parts industry documented in previous literature. Our results clearly show that underestimating this type of jumps might lead to substantial misjudgements in a firm’s decision-making processes. For instance, it may lead to profitable projects being rejected when jump diffusion is low, or negative expanded net present value projects being accepted.
Document language English
Publication Year 2009
Page/Pages p. 2977-2989
Journal Applied Economics, 41 (2009) 23
DOI http://dx.doi.org/10.1080/00036840701335603
Status Postprint; peer reviewed
Licence PEER Licence Agreement (applicable only to documents from PEER project)