Interest Rates, Inflation and the Value of Growth Options
Posted: 16 Oct 1998
A company's investment opportunities are analogous to options, and options react differently to interest rate changes than other types of assets. We examine growth option sensitivity to inflation-induced changes in interest rates using a binomial model. We find that growth options are generally less sensitive to these rate changes than assets in place, but contrary to the usual call option intuition, the value of growth options frequently decreases as interest rates increase. The magnitude (and sign) of their interest sensitivity depends critically on how much of those changes in expected inflation rates can be "flowed through" to changes in the project's nominal cash flows.
JEL Classification: G31, G32
Suggested Citation: Suggested Citation