Real Options with Market Risks and Private Risks

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