Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options
University of Richmond - E. Claiborne Robins School of Business
Timothy Falcon Crack
University of Otago - Department of Finance and Quantitative Analysis
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.
Number of Pages in PDF File: 54
JEL Classification: A23, G13
Date posted: December 27, 2000
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