A General Decision-Tree Approach to Real Option Valuation

The common paradigm for risk-neutral real-option pricing is a special case encompassed within our general model for valuing investment opportunities. Risk-neutral real option prices deviate from the risk-averse real option values that apply in an incomplete market, giving different rankings of investment opportunities and different optimal exercise strategies. Unlike risk-neutral prices, more general real option values often decrease with the volatility of the asset price. They also depend on the structure of fixed and variable investment costs, the expected return of the underlying asset, the frequency of decision opportunities, the price of the asset relative to initial wealth, the investor’s risk tolerance and its sensitivity to wealth. We explain how these factors affect the ranking of real option values under a standard geometric Brownian motion for the asset price. Numerical examples also consider ‘boom-bust’ or mean-reverting price scenarios and investments with positive or negative cash flows.