Valuing Pilot Project Investments in Incomplete Markets : A Compound Option Approach
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
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.:
- Roberts, Kevin & Weitzman, Martin L, 1981.
"Funding Criteria for Research, Development, and Exploration Projects,"
Econometric Society, vol. 49(5), pages 1261-1288, September.
- M. L. Weitzman & K. Roberts, 1979. "Funding Criteria for Research, Development and Exploration Projects," Working papers 234, Massachusetts Institute of Technology (MIT), Department of Economics.
- Gene M. Grossman & Carl Shapiro, 1986. "Optimal Dynamic R&D Programs," RAND Journal of Economics, The RAND Corporation, vol. 17(4), pages 581-593, Winter.
- Gene M. Grossman & Carl Shapiro, 1985. "Optimal Dynamic R&D Programs," NBER Working Papers 1658, National Bureau of Economic Research, Inc.
- Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
- Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
- Eduardo S. Schwartz & Carlos Zozaya-Gorostiza, 2003. "Investment Under Uncertainty in Information Technology: Acquisition and Development Projects," Management Science, INFORMS, vol. 49(1), pages 57-70, January.
- Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:sce:scecf5:73. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)
If references are entirely missing, you can add them using this form.