Learning Options and Binomial Trees

19 Pages Posted: 15 Feb 2009 Last revised: 7 Apr 2010

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: April 6, 2010


This paper modifies the standard binomial option pricing approach to real options analysis so that it can incorporate learning options. These options allow a manager to gather information about a potential investment payoff prior to investment occurring. The project's overall volatility will vary in the run-up to investment, being higher when the manager gathers more information about the eventual investment payoff. This paper shows how to construct a recombining tree for the project's anticipated value by making the time steps shorter during periods of high volatility. It describes a simple scheme for calculating the lengths of these steps and the risk-neutral probabilities that are needed to calculate arbitrage-free asset prices.

Keywords: real options, learning options, information gathering, binomial option pricing model

JEL Classification: G31, D81, C61

Suggested Citation

Guthrie, Graeme, Learning Options and Binomial Trees (April 6, 2010). Available at SSRN: https://ssrn.com/abstract=1343430 or http://dx.doi.org/10.2139/ssrn.1343430

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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