Valuing Real Options with Implied Binomial Trees

13 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: October 21, 2004

Abstract

We value a real option (a lease) using an implied binomial tree (IBT). IBTs use information embedded in the prices of traded options to calibrate a pricing tree for valuing other options on the same underlying asset. By doing so, IBTs capture excess skewness and kurtosis in the underlying asset return distribution. Traditional binomial trees ignore this information and this can lead to biased option prices. The IBT calibration is attractive because it is easy to implement relative to analytical models that capture excess skewness and kurtosis through estimation of Poisson jumps or a model of stochastic volatility.

Keywords: Real Options, Implied Binomial Trees

JEL Classification: G12, G13, G31

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon and Schwartz, Adam, Valuing Real Options with Implied Binomial Trees (October 21, 2004). Available at SSRN: https://ssrn.com/abstract=644601 or http://dx.doi.org/10.2139/ssrn.644601

Thomas M. Arnold (Contact Author)

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

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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