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Pricing real options under the constant elasticity of variance diffusion
Author(s) -
Carlos Dias José,
Pedro Vidal Nunes João
Publication year - 2011
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.20468
Subject(s) - economics , econometrics , constant elasticity of variance model , volatility (finance) , geometric brownian motion , variance (accounting) , elasticity (physics) , state variable , constant (computer programming) , financial economics , volatility smile , diffusion process , forward volatility , computer science , physics , economy , accounting , thermodynamics , programming language , service (business)
Much of the work on real options assumes that the underlying state variable follows a geometric Brownian motion with constant volatility. This paper uses a more general assumption for the state variable process that better captures the empirical regularities found in commodity markets. We use the constant elasticity of variance diffusion, where volatility is a function of underlying asset prices, and we provide analytic solutions for perpetual American options. We show that a firm that uses the standard lognormal assumption is exposed to significant errors of analysis, which may lead to nonoptimal investment and disinvestment decisions. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:230–250, 2011