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Real Options with Priced Regime-Switching Risk

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  • John Driffill
  • Martin Sola
  • Turalay Kenc

Abstract

e develop a model of regime-switching risk premia as well as regimedependent factor risk premia to price real options. The model incorporates the observation that the underlying risky income streams of real options are subject to discrete shifts over time as well as random changes. The presence of discrete shifts is due to systematic and unsystematic risk associated with changes in business cycles or in economic policy regimes or events such as takeovers, major changes in business plans. We analyze the impact of regimeswitching behavior on the valuation of projects and investment opportunities. We find that accounting for Markov switching risk results in a delay in the expected timing of the investment while the regime-specific factor risk premia make the possibility of a regime shift more pronounced.

Suggested Citation

  • John Driffill & Martin Sola & Turalay Kenc, 2009. "Real Options with Priced Regime-Switching Risk," Department of Economics Working Papers 2009-09, Universidad Torcuato Di Tella.
    • Handle: RePEc:udt:wpecon:2009-09
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    Cited by:

    1. Siu, Tak Kuen, 2023. "European option pricing with market frictions, regime switches and model uncertainty," Insurance: Mathematics and Economics, Elsevier, vol. 113(C), pages 233-250.
    2. Armerin, Fredrik & Gunnelin, Åke, 2019. "Competitive investment with varying risk premia," Working Paper Series 19/12, Royal Institute of Technology, Department of Real Estate and Construction Management & Banking and Finance.
    3. Goto, Makoto & Nishide, Katsumasa & Takashima, Ryuta, 2017. "Leaders, followers, and equity risk premiums in booms and busts," Journal of Banking & Finance, Elsevier, vol. 81(C), pages 207-220.
    4. Makoto Goto & Katsumasa Nishide & Ryuta Takashima, 2013. "Irreversible Investment under Competition with a Markov Switching Regime," KIER Working Papers 861, Kyoto University, Institute of Economic Research.

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    More about this item

    Keywords

    Regime-Switching Risk Premia; Regime-Dependent Risk Premia; Real Options.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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