Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options

Abstract:     
We extend a popular binomial model to allow for option pricing using real-world rather than risk-neutral world probabilities. There are three benefits. First, our model allows direct inference about relevant real-world probabilities (e.g. of success in a real-option project, of default on a corporate bond, or of an American-style option finishing in the money). Second, practitioners using our model for corporate real-option applications completely avoid managerial anxiety that competing risk-neutral models generate when they use risk-free discount rates for risky cash flows. Third, our model simplifies option pricing when higher moments (e.g., skewness and kurtosis) appear in asset pricing models.

JEL Classifications: A23, G13

Working Paper Series