Real Options in a dynamic asset pricing model with stochastic asset prices and interest rates.

Thesis by Bjarne Munkerod Andersen

Abstract:

    A general dynamic asset pricing model is presented along with two traditional methods for arbitrage-free pricing of securities. Within this framework a special real option, namely the option (of waiting) to invest irreversibly in a project within a given time-frame, is subjected to a detailed analysis in two special settings. The first setting assumes that the interest rate is the only uncertain variable, whereas the second setting also allows asset price uncertainty.
    Standard (real) option pricing results are obtained and some new insights developed. Two of these results are that the value of an investment under interest rate uncertainty and/or asset price uncertainty, at the point where it is optimally undertaken, is significantly positive, and that the investment is strictly delayed compared to the point of break-even.
    Two distinctions, the traditonal distinction between variable and fixed costs, and a distinction between uncertain and certain payments are shown to be important in the pricing of real options. It is also shown that real options are likely to be more prone to interest rate uncertainty than the standard financial options because of the existence of certain payments at times later than the time of optimal investment/exercise. This makes an assumption of fixed interest rates more critical when dealing with real options.
    Finally, a general formula for pricing projects including one or several real options is presented.

The author is grateful for financial support contributed by the Aarhus University Research Foundation.

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