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Modelling the number of customers as a birth and death process

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Author Info

  • Helena Pinto
  • Sydney Howell
  • Dean Paxson
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    Abstract

    Birth and death may be a better model than Brownian motion for many physical processes, which real options models will increasingly need to deal with. In this paper, we value a perpetual American call option, which gives the monopoly right to invest in a market in which the number of active customers (and hence the sales rate) follows a birth and death process. The problem contains a singular point, and we develop a mixed analytic/numeric method for handling this singular point, based on the method of Frobenius. The method may be useful for other cases of singular points. The birth and death model gives lower option values than the geometric Brownian motion model, except at very low volatilities, so that if a firm incorrectly assumes a geometric Brownian motion process in place of a birth and death process, it will invest too seldom and too late.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/13518470802042021
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal The European Journal of Finance.

    Volume (Year): 15 (2009)
    Issue (Month): 2 ()
    Pages: 105-118

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    Handle: RePEc:taf:eurjfi:v:15:y:2009:i:2:p:105-118

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    Related research

    Keywords: real options; birth and death processes and Frobenius method;

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    Cited by:
    1. Dias, José Carlos & Shackleton, Mark B., 2011. "Hysteresis effects under CIR interest rates," European Journal of Operational Research, Elsevier, vol. 211(3), pages 594-600, June.

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