Model Risk in Real Option Valuation

TL;DR

This paper presents a decision tree framework to evaluate model risk in real option valuation, highlighting how assumptions impact investment decision metrics and challenging some established beliefs.

Contribution

It introduces a comprehensive decision tree approach to assess model risk in real options, considering various factors affecting valuation and revealing counterintuitive effects.

Findings

Real option values can decrease with increased volatility.

Higher investment costs may lead to higher real option values.

Model assumptions significantly influence valuation outcomes.

Abstract

We introduce a general decision tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor's risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylized facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs.