Project Choice in Real Option Pricing Framework

Abstract:     
Black-Scholes-Merton theory of option pricing has carved out a respectable place in finance theory, particularly after Scholes and Merton got the Nobel Prize in Economics in 1997 for their contribution. One of the important areas of the application of the theory is that of project choice under uncertainty. It captures the strategic dimensions of investment decision making process. The theory has not been popular in India because of the absence of options trading in the capital market. Yet, the model can be used in appraising investment projects particularly where the projects are implemented in several stages and have growth options.

This paper outlines the findings of an earlier study by the authors concerning national economic profitability of a polyester filament yarn project, having growth option, promoted in an assisted sector by a State Industrial Development Corporation in India where uncertainty was captured in a sensitivity analytic framework. Then, the data concerning the project was used for assessing national economic profitability of the project in a real option-pricing framework. The theoretical framework of national economic profitability, as developed by unido guidelines, has been combined with Black-Scholes-Merton theory. It is seen that option valuation model captures the dynamic reality of a growth option in a simpler manner and thereby enriches the net present value methodology of project choice.

Number of Pages in PDF File: 18

Keywords: Economic Analysis, Option Pricing, India

JEL Classification: G20, G21, G28

Accepted Paper Series