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A General Approach to Real Option Valuation with Application to Real Estate Investments

University of Reading, ICMA Centre Discussion Paper No. DP2012-04

43 Pages Posted: 25 Jan 2012 Last revised: 28 Feb 2013

Carol Alexander

University of Sussex - School of Business, Management and Economics

Xi Chen

University of Reading - ICMA Centre; University of Sussex - School of Business, Management and Economics

Date Written: January 23, 2012

Abstract

We model investment opportunities with a single source of uncertainty, i.e. the market price of the investment. Investment cost can be predetermined or perfectly correlated with the market price. The common paradigm for risk-neutral real-option pricing is a special case encompassed within our general framework, and we analyse the relationship between standard real option prices and the more general risk-averse real option values. Numerical examples illustrate how these general values depend on the frequency of decision opportunities, the investor’s risk tolerance and its sensitivity to wealth, his expected return and volatility of the underlying asset, and the price of the asset relative to initial wealth. Specific applications to real estate include property investment under ‘boom-bust’ or mean-reverting price scenarios, and buy-to-let or land-development opportunities.

Keywords: CARA, CRRA, certain equivalent, development, divestment, displaced log utility, exponential utility, HARA, investment, mean-reversion, property boom, real option, risk aversion, risk tolerance

JEL Classification: G11, G30

Suggested Citation

Alexander, Carol and Chen, Xi, A General Approach to Real Option Valuation with Application to Real Estate Investments (January 23, 2012). University of Reading, ICMA Centre Discussion Paper No. DP2012-04. Available at SSRN: https://ssrn.com/abstract=1990957 or http://dx.doi.org/10.2139/ssrn.1990957

Carol Alexander

University of Sussex - School of Business, Management and Economics ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.sussex.ac.uk/bam

Xi Chen (Contact Author)

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

University of Sussex - School of Business, Management and Economics ( email )

Falmer, Brighton BN1 9SL
United Kingdom

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