Arithmetic Brownian motion and real options
AbstractWe treat real option value when the underlying process is arithmetic Brownian motion (ABM). In contrast to the more common assumption of geometric Brownian motion (GBM) and multiplicative diffusion, with ABM the underlying project value is expressed as an additive process. Its variance remains constant over time rather than rising or falling along with the project’s value, even admitting the possibility of negative values. This is a more compelling paradigm for projects that are managed as a component of overall firm value. After outlining the case for ABM, we derive analytical formulas for European calls and puts on dividend-paying assets as well as a numerical algorithm for American-style and other more complex options based on ABM. We also provide examples of their use.
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Bibliographic InfoArticle provided by Elsevier in its journal European Journal of Operational Research.
Volume (Year): 219 (2012)
Issue (Month): 1 ()
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Web page: http://www.elsevier.com/locate/eor
Investment analysis; Real options; Risk-neutral valuation; Arithmetic Brownian motion;
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