Valuing Real Options Using Implied Binomial Trees and Commodity Futures Options

38 Pages Posted: 8 Jan 2005

See all articles by Tom Arnold

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Adam Schwartz

Washington and Lee University - Department of Business Administration

Date Written: April 11, 2006

Abstract

A real option on a commodity is valued using an implied binomial tree (IBT) calibrated using commodity futures options prices. Estimating an IBT in the absence of spot options (the norm for commodities) allows real option models to be calibrated for the first time to market-implied probability distributions for commodity prices. Also, the existence of long-dated futures options means that good volatility estimates may now be incorporated into capital budgeting evaluations of real options projects with long planning horizons. An example is given using gold futures options and a real option to extract gold from a mine. We include a unique out-of-sample test that shows how option pricing errors evolve on sub-trees emanating from future levels of the underlying.

Keywords: Real Options, Implied Binomial Trees, Commodity Futures Options, Commodities

JEL Classification: G12, G13, G31

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon and Schwartz, Adam, Valuing Real Options Using Implied Binomial Trees and Commodity Futures Options (April 11, 2006). Available at SSRN: https://ssrn.com/abstract=644581 or http://dx.doi.org/10.2139/ssrn.644581

Thomas M. Arnold

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

1 Gateway Drive
Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack (Contact Author)

University of Otago - Department of Accountancy and Finance ( email )

Dunedin
New Zealand

Adam Schwartz

Washington and Lee University - Department of Business Administration ( email )

Lexington, VA 24450
United States

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