Cash Flow Simulation Embedded Real Options

Abstract

Cash flow simulation embedded option is an option whose value is based on choosing the optimal decision in each time step during a single cash flow calculation simulation run. Cash flow simulation embedded options are mostly operative options with continuous, gradual and nearly immediate exercise with well-known payoff or benefits. Typically these options are difficult to model with other methods than Monte Carlo simulation. However, cash flow simulation embedded options and the common, once exercisable options can be applied simultaneously in an investment valuation by using the simulated cash flow with embedded options as the underlying asset for the lattice, which is then used in valuing other lattice type options and their interactions.

Keywords: real options, cash flow simulation