Model Risk in Real Option Valuation

Alexander, C., & Chen, X. (2021). Model risk in real option valuation. Annals of Operations Research, 299(1), 1025-1056.

35 Pages Posted: 25 Jan 2012 Last revised: 17 Jul 2023

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Xi Chen

University of Sussex Business School

Date Written: January 23, 2012

Abstract

We introduce a general decision tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor's risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylized facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs.

Keywords: CARA, CRRA, certain equivalent, decision tree, divestment, Hyperbolic Absolute Risk Aversion, investment, mean-reversion, risk aversion, risk tolerance

JEL Classification: C44, D81, G13, G30

Suggested Citation

Alexander, Carol and Chen, Xi, Model Risk in Real Option Valuation (January 23, 2012). Alexander, C., & Chen, X. (2021). Model risk in real option valuation. Annals of Operations Research, 299(1), 1025-1056., Available at SSRN: https://ssrn.com/abstract=1990957

Carol Alexander

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.coalexander.com

Peking University HSBC Business School ( email )

Xi Chen (Contact Author)

University of Sussex Business School ( email )

Jubilee Building
Falmer, Brighton BN1 9SL
United Kingdom

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