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Real-Option Valuation in a Finite-Time, Incomplete Market with Jump Diffusion and Investor-Utility Inflation

Author

Listed:
  • Timothy Hillman

    (Centre for Actuarial Studies, Department of Economics, The University of Melbourne, VIC 3010, Australia)

  • Nan Zhang

    (Centre for Actuarial Studies, Department of Economics, The University of Melbourne, VIC 3010, Australia
    School of Statistics, East China Normal University, 500 Dongchuan Road, Shanghai 200241, China)

  • Zhuo Jin

    (Centre for Actuarial Studies, Department of Economics, The University of Melbourne, VIC 3010, Australia)

Abstract

We extend an existing numerical model (Grasselli (2011)) for valuing a real option to invest in a capital project in an incomplete market with a finite time horizon. In doing so, we include two separate effects: the possibility that the project value is partly describable according to a jump-diffusion process, and incorporation of a time-dependent investor utility function, taking into account the effect of inflation. We adopt a discrete approximation to the jump process, whose parameters are restricted in order to preserve the drift and the volatility of the project-value process that it modifies. By controlling for these low-order effects, the higher-order effects may be considered in isolation. Our simulated results demonstrate that the inclusion of the jump process tends to decrease the value of the option, and expand the circumstances under which it should be exercised. Our results also demonstrate that an appropriate selection of the time-dependent investor utility function yields more reasonable investor-behaviour predictions regarding the decision to exercise the option, than would occur otherwise.

Suggested Citation

  • Timothy Hillman & Nan Zhang & Zhuo Jin, 2018. "Real-Option Valuation in a Finite-Time, Incomplete Market with Jump Diffusion and Investor-Utility Inflation," Risks, MDPI, vol. 6(2), pages 1-20, May.
    • Handle: RePEc:gam:jrisks:v:6:y:2018:i:2:p:51-:d:144607
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    References listed on IDEAS

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    Cited by:

    1. Carlos Andres Zapata Quimbayo & Carlos Armando Mej¨ªa Vega, 2019. "Real Options Valuation in Gold Mining Projects under Multinomial Tree Approach," Business and Economic Research, Macrothink Institute, vol. 9(3), pages 204-218, September.

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