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

Author

Listed:
  • Eymen Errais

    (Managment Science and Engineering Stanford University)

  • Jeffrey Sadowsky

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

Suggested Citation

  • Eymen Errais & Jeffrey Sadowsky, 2005. "Valuing Pilot Project Investments in Incomplete Markets : A Compound Option Approach," Computing in Economics and Finance 2005 73, Society for Computational Economics.
    • Handle: RePEc:sce:scecf5:73
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    File URL: http://repec.org/sce2005/up.1062.1106092940.pdf
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    References listed on IDEAS

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    5. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    real options; dynamic programming; incomplete markets;
    All these keywords.

    JEL classification:

    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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