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Alternative Approaches for Solving Real-Options Problems

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  • James E. Smith

    (Fuqua School of Business, Duke University, Box 90120, Durham, North Carolina 27708-0120)

Abstract

Brandao et al. (2005) describe an approach for using traditional decision analysis tools to solve real-option valuation problems. Their approach calls for a mix of discounted cash flow analysis and risk-neutral valuation methods and is implemented using Monte Carlo simulation and binomial decision trees. In this note, I critique their approach and discuss some alternative approaches for solving these kinds of problems. My criticisms and suggestions concern implementation issues as well as more fundamental issues. On implementation, I discuss the use of binomial lattices instead of trees, and alternative methods for estimating volatilities. More fundamentally, I discuss alternative approaches that rely entirely on risk-neutral valuation and model the uncertainties in the problem more directly.

Suggested Citation

  • James E. Smith, 2005. "Alternative Approaches for Solving Real-Options Problems," Decision Analysis, INFORMS, vol. 2(2), pages 89-102, June.
    • Handle: RePEc:inm:ordeca:v:2:y:2005:i:2:p:89-102
    DOI: 10.1287/deca.1050.0041
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    References listed on IDEAS

    as
    1. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
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    4. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-384, March.
    5. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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    7. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    8. Luiz E. Brandão & James S. Dyer & Warren J. Hahn, 2005. "Using Binomial Decision Trees to Solve Real-Option Valuation Problems," Decision Analysis, INFORMS, vol. 2(2), pages 69-88, June.
    9. James E. Smith & Kevin F. McCardle, 1999. "Options in the Real World: Lessons Learned in Evaluating Oil and Gas Investments," Operations Research, INFORMS, vol. 47(1), pages 1-15, February.
    10. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
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