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Valuing Pilot Project Investments in Incomplete Markets : A Compound Option Approach

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  • Eymen Errais

    ()
    (Managment Science and Engineering Stanford University)

  • Jeffrey Sadowsky
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    Abstract

    We 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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    File URL: http://repec.org/sce2005/up.1062.1106092940.pdf
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    Bibliographic Info

    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 73.

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    Date of creation: 11 Nov 2005
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    Handle: RePEc:sce:scecf5:73

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    Keywords: real options; dynamic programming; incomplete markets;

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    1. Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July.
    2. Eduardo S. Schwartz & Carlos Zozaya-Gorostiza, 2003. "Investment Under Uncertainty in Information Technology: Acquisition and Development Projects," Management Science, INFORMS, vol. 49(1), pages 57-70, January.
    3. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
    4. Gene M. Grossman & Carl Shapiro, 1986. "Optimal Dynamic R&D Programs," RAND Journal of Economics, The RAND Corporation, vol. 17(4), pages 581-593, Winter.
    5. Roberts, Kevin & Weitzman, Martin L, 1981. "Funding Criteria for Research, Development, and Exploration Projects," Econometrica, Econometric Society, vol. 49(5), pages 1261-88, September.
    6. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    7. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
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