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Can properly discounted projects follow geometric Brownian motion?

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  • Juho Kanniainen

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    Abstract

    The geometric Brownian motion is routinely used as a dynamic model of underlying project value in real option analysis, perhaps for reasons of analytic tractability. By characterizing a stochastic state variable of future cash flows, this paper considers how transformations between a state variable and cash flows are related to project volatility and drift, and specifies necessary and sufficient conditions for project volatility and drift to be time-varying, a topic that is important for real option analysis because project value and its fluctuation can only seldom be estimated from data. This study also shows how fixed costs can cause project volatility to be mean-reverting. We conclude that the conditions of geometric Brownian motion can only rarely be met, and therefore real option analysis should be based on models of cash flow factors rather than a direct model of project value. Copyright Springer-Verlag 2009

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    Bibliographic Info

    Article provided by Springer in its journal Mathematical Methods of Operations Research.

    Volume (Year): 70 (2009)
    Issue (Month): 3 (December)
    Pages: 435-450

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    Handle: RePEc:spr:compst:v:70:y:2009:i:3:p:435-450

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    Related research

    Keywords: Real options; Stochastic processes; Geometric Brownian motion; Stochastic volatility; Present value model;

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    Cited by:
    1. Reindorp, Matthew J. & Fu, Michael C., 2011. "Capital renewal as a real option," European Journal of Operational Research, Elsevier, vol. 214(1), pages 109-117, October.
    2. Kanniainen, Juho & Piché, Robert, 2013. "Stock price dynamics and option valuations under volatility feedback effect," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 392(4), pages 722-740.

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