Valuing Real Options with Implied Binomial Trees
University of Richmond - E. Claiborne Robins School of Business
Timothy Falcon Crack
University of Otago - Department of Finance and Quantitative Analysis
Washington and Lee University - Department of Business Administration
October 21, 2004
We value a real option (a lease) using an implied binomial tree (IBT). IBTs use information embedded in the prices of traded options to calibrate a pricing tree for valuing other options on the same underlying asset. By doing so, IBTs capture excess skewness and kurtosis in the underlying asset return distribution. Traditional binomial trees ignore this information and this can lead to biased option prices. The IBT calibration is attractive because it is easy to implement relative to analytical models that capture excess skewness and kurtosis through estimation of Poisson jumps or a model of stochastic volatility.
Number of Pages in PDF File: 13
Keywords: Real Options, Implied Binomial Trees
JEL Classification: G12, G13, G31
Date posted: January 8, 2005
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