Real Options with Market Risks and Private Risks

22 Pages Posted: 30 Aug 2006

See all articles by Antonio S. Mello

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Unyong Pyo

Brock University

Abstract

Real investment decisions often include risks that are not priced in the capital markets. Valuing real options with private risks is not trivial. Private risks cannot be evaluated with arbitrage arguments used in option pricing techniques (OPT). This article values an option to defer a capital investment decision subject to market, as well as private risk. OPT only provides bounds on the value of this option, so an equilibrium approach is used to obtain consistent and precise estimates. The article addresses two other issues, often the subject of much debate: does private risk diminish the value of the option or enhance it, as does market risk? Does the real option's sensitivity to risk depend on the sequence between private and market risk and to which type of risk occurs first?

Keywords: market risks, private risks, real options

JEL Classification: G12

Suggested Citation

Mello, Antonio S. and Pyo, Unyong, Real Options with Market Risks and Private Risks. Journal of Applied Corporate Finance, Vol. 15, No. 2, Winter 2003, Available at SSRN: https://ssrn.com/abstract=927477

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-263-3423 (Phone)
608-265-4195 (Fax)

Unyong Pyo (Contact Author)

Brock University ( email )

500 Glenridge Avenue
St. Catherines, Ontario L2S 3A1
Canada
905-688-5550 ext. 3147 (Phone)
905-378-5723 (Fax)

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