Real options and the universal bad news principle
AbstractA 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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Date of creation: 09 Sep 2004
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- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
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