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Real options and the universal bad news principle

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Author Info
Svetlana Boyarchenko (The University of Texas at Austin)
Sergei Levendorskii (The University of Texas at Austin)

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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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Publisher Info
Paper provided by EconWPA in its series Finance with number 0405011.

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Length: 34 pages
Date of creation: 06 May 2004
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Handle: RePEc:wpa:wuwpfi:0405011

Note: Type of Document - pdf; pages: 34
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Web page: http://129.3.20.41

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Related research
Keywords: exit and entry; emdebbed options; technology adoption; capital expansion;

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Find related papers by JEL classification:
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Angus Deaton & Guy Laroque, 1990. "On The Behavior of Commodity Prices," NBER Working Papers 3439, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. 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. [Downloadable!] (restricted)
    Other versions:
  3. 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. [Downloadable!] (restricted)
  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. [Downloadable!] (restricted)
  5. Svetlana Boyarchenko, 2004. "Irreversible Decisions and Record-Setting News Principles," American Economic Review, American Economic Association, vol. 94(3), pages 557-568, June. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Svetlana Boyarchenko & Sergey Levendorskiy, 2004. "Optimal stopping made easy," Finance 0410016, EconWPA. [Downloadable!]
    Other versions:
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