Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options

54 Pages Posted: 27 Dec 2000

See all articles by Tom Arnold

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago

Date Written: August 2000

Abstract

We extend a popular binomial model to allow for option pricing using real-world rather than risk-neutral world probabilities. There are three benefits. First, our model allows direct inference about relevant real-world probabilities (e.g. of success in a real-option project, of default on a corporate bond, or of an American-style option finishing in the money). Second, practitioners using our model for corporate real-option applications completely avoid managerial anxiety that competing risk-neutral models generate when they use risk-free discount rates for risky cash flows. Third, our model simplifies option pricing when higher moments (e.g., skewness and kurtosis) appear in asset pricing models.

JEL Classification: A23, G13

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon, Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options (August 2000). Available at SSRN: https://ssrn.com/abstract=240554 or http://dx.doi.org/10.2139/ssrn.240554

Thomas M. Arnold

University of Richmond - E. Claiborne Robins School of Business ( email )

102 UR Drive
University of Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack (Contact Author)

University of Otago ( email )

P.O. Box 56
Dunedin, Otago 9010
New Zealand

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