Incomplete Information, Exercise Policy, and the Valuation of Claims on Noisy Real Assets

Abstract:     
Real option values often depend on assets that are infrequently traded and lack a continuously reliable value benchmark. In this paper we develop a methodology for valuing a wide variety of claims on noisy real assets, including those that are European, American, compound and strategic in nature. When asset value information is incomplete, a weighted average of the noisy signal of asset value and the asset's forward price is used to determine conditional asset value and option exercise policy. We show that exercise policy can differ dramatically from a policy that results when information is complete. Applications involving discount debt, levered lease transactions with coupon debt financing, and imperfect competition in new product markets with information spillover are considered to illustrate our methodology. The potential implementation of information acquisition technology, implications for the observed =EBunderexercise=ED of certain real options, and the likelihood of investment cascading behavior are also analyzed.

JEL Classification: G13

working papers series