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Valuing real options using implied binomial trees and commodity futures options

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  • Tom Arnold
  • Timothy Falcon Crack
  • Adam Schwartz

Abstract

A real option on a commodity is valued using an implied binomial tree (IBT) calibrated using commodity futures options prices. Estimating an IBT in the absence of spot options (the norm for commodities) allows real option models to be calibrated for the first time to market‐implied probability distributions for commodity prices. In addition, the existence of long‐dated futures options means that good volatility estimates may now be incorporated into capital budgeting evaluations of real options projects with long planning horizons. An example is given using gold futures options and a real option to extract gold from a mine. A detailed out‐of‐sample test is included that shows how IBT option pricing errors evolve on subtrees emanating from future levels of the underlying asset. © 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:203–226, 2007

Suggested Citation

  • Tom Arnold & Timothy Falcon Crack & Adam Schwartz, 2007. "Valuing real options using implied binomial trees and commodity futures options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 27(3), pages 203-226, March.
    • Handle: RePEc:wly:jfutmk:v:27:y:2007:i:3:p:203-226
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    Cited by:

    1. Tianyang Wang & James S. Dyer, 2010. "Valuing Multifactor Real Options Using an Implied Binomial Tree," Decision Analysis, INFORMS, vol. 7(2), pages 185-195, June.
    2. Seiji Harikae & James S. Dyer & Tianyang Wang, 2021. "Valuing Real Options in the Volatile Real World," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 171-189, January.

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