A General Approach to Real Option Valuation with Application to Real Estate Investments

Abstract:     
We model investment opportunities with a single source of uncertainty, i.e. the market price of the investment. Investment cost can be predetermined or perfectly correlated with the market price. The common paradigm for risk-neutral real-option pricing is a special case encompassed within our general framework, and we analyse the relationship between standard real option prices and the more general risk-averse real option values. Numerical examples illustrate how these general values depend on the frequency of decision opportunities, the investor’s risk tolerance and its sensitivity to wealth, his expected return and volatility of the underlying asset, and the price of the asset relative to initial wealth. Specific applications to real estate include property investment under ‘boom-bust’ or mean-reverting price scenarios, and buy-to-let or land-development opportunities.

Number of Pages in PDF File: 43

Keywords: CARA, CRRA, certain equivalent, development, divestment, displaced log utility, exponential utility, HARA, investment, mean-reversion, property boom, real option, risk aversion, risk tolerance

JEL Classification: G11, G30

working papers series