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Real options and the universal bad news principle

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  • Svetlana Boyarchenko
  • Sergei Levendorskii

Abstract

A general framework for pricing of real options in continuous time for wide classes of payoff streams that are monotone functions of a Levy process is provided. Exercise rules are formulated in terms of statistics of record-setting low payoffs and can be viewed as an extension of Bernanke's bad news principle. To illustrate the framework, we solve analytically the following problems: a capital expansion program when the underlying price exhibits mean reverting features; an entry decision with an option to exit, and a new technology adoption. The effects of industry specific and idiosyncratic risks are separated. The third model is driven by two factors: one describes the dynamics of the frontier technology, the other incorporates non-technological uncertainty. The former factor follows a process with upward jumps. The impact of these factors on new technology adoption is analyzed.

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Bibliographic Info

Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000000430.

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Date of creation: 09 Sep 2004
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Handle: RePEc:cla:levrem:122247000000000430

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  1. Svetlana Boyarchenko & Sergei Levendorskii, 2004. "Universal bad news principle and pricing of options on dividend-paying assets," Papers cond-mat/0404108, arXiv.org.
  2. Angus Deaton & Guy Laroque, 1990. "On The Behavior of Commodity Prices," NBER Working Papers 3439, National Bureau of Economic Research, Inc.
  3. Abel, Andrew B. & Eberly, Janice C., 1999. "The effects of irreversibility and uncertainty on capital accumulation," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 339-377, December.
  4. Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
  5. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
  6. Svetlana Boyarchenko, 2004. "Irreversible Decisions and Record-Setting News Principles," American Economic Review, American Economic Association, vol. 94(3), pages 557-568, June.
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Cited by:
  1. Svetlana Boyarchenko & Sergey Levendorskiy, 2004. "Optimal stopping made easy," Finance 0410016, EconWPA.
  2. Flavia Barsotti, 2012. "Optimal Capital Structure with Endogenous Default and Volatility Risk," Working Papers - Mathematical Economics 2012-02, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.

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