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Capital Investment as Real Options: A Note on Dixit-Pindyck Model

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  • Termos, Ali

Abstract

This paper applies Contingent Claims model a la Dixit and Pindyck (1994), on bank investment. Banks are indifferent between investing their assets on their own and extending loans to investors. The critical decision faced by the banker is the timing of the investment decision and its uncertainty. When banks make an irreversible investment decision they exercise the option to invest and give up the opportunity of waiting for new information to arrive. This lost option value is incorporated in the investment cost. Therefore, the value of the project must exceed the investment cost by the value of keeping the investment option alive. Using a third-moment mean-reversion process of the investment’s volatility, the model shows that a higher mean-reversion parameter reduces both the value of the option to invest and the critical value at which the project deems feasible.

Suggested Citation

  • Termos, Ali, 2008. "Capital Investment as Real Options: A Note on Dixit-Pindyck Model," MPRA Paper 9352, University Library of Munich, Germany, revised 04 Mar 2008.
    • Handle: RePEc:pra:mprapa:9352
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    References listed on IDEAS

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    1. Varian, Hal R, 1985. "Divergence of Opinion in Complete Markets: A Note," Journal of Finance, American Finance Association, vol. 40(1), pages 309-317, March.
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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