Valuing Pilot Project Investments in Incomplete Markets : A Compound Option Approach
AbstractWe introduce a general framework to value pilot project investments under the presence of both, market and technical uncertainty. The model generalizes different settings introduced previously in the literature. By distinguishing between the pilot and the commercial stages of the project we are able to frame the problem as a compound perpetual Bermudan option. We work on an incomplete market setting where market uncertainty is spanned by tradable assets and technical uncertainty is private to the firm. The value of these investment opportunities as well as the optimal exercise problem are solved by approximate dynamic programming techniques. We prove the convergence of our algorithm and derive a theoretical bound on how the errors compound as the number of stages of the compound option is increased. Furthermore, we show some numerical results and provide an economic interpretation of the model dynamics
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 73.
Date of creation: 11 Nov 2005
Date of revision:
real options; dynamic programming; incomplete markets;
Find related papers by JEL classification:
- C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
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- M. L. Weitzman & K. Roberts, 1979.
"Funding Criteria for Research, Development and Exploration Projects,"
234, Massachusetts Institute of Technology (MIT), Department of Economics.
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- Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July.
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