European Real Options: An Intuitive Algorithm for the Black-Scholes Formula
Vinay T. Datar
Scott H. Mathews
The Boeing Company
Journal of Applied Finance, Vol. 14, No. 1, Spring/Summer 2004
We propose an intuitive method that is algebraically equivalent to the Black-Scholes formula. The main advantage of this method is its simplicity and transparency. Further, the method implicitly adjusts the discount rate to account for the underlying risk. Our approach relies on information that is available in the traditional project analysis using the net present value technique. When Black-Scholes assumptions are compromised in real projects, our method may provide a better approximation of call value. Our preliminary results suggest that our method provides a reasonable approximation for both binomial and jump diffusion processes where the terminal distributions need not be log-normal.
Number of Pages in PDF File: 7
JEL Classification: G10, G13
Date posted: January 6, 2005
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