Real Option with Uncertain Expected Return

Abstract:     
In this paper we extend the standard real options model to consider the situation where the expected return of the cash flow generated by an irreversible investment project is uncertain and it is governed by a continuous-time Markov chain with two states. We provide closed-form solutions if the expected return is observable (complete information case). If the expected return is unobservable (partial information case), we provide numerical solutions by finite difference methods. The information value, i.e. the difference of the values of the option to invest between the two cases, is derived numerically. We discuss the impacts of the uncertain expected return upon the information value and the pricing and timing of the option to invest under the two cases respectively.

Number of Pages in PDF File: 22

Keywords: Real Options, Investment Threshold, Economic Regime, Partial Information, Information Value

JEL Classification: D11, D91, E21

working papers series