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The Expected Return and Exercise Time of Merton‐style Real Options
Author(s) -
Shackleton Mark,
Wojakowski Rafal
Publication year - 2002
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/1468-5957.00442
Subject(s) - call option , volatility (finance) , economics , expected return , rate of return , financial economics , actuarial science , econometrics , finance , portfolio
We analyse the rate of return and expected exercise time of Merton‐style options (1973) employed in many real option situations where the possibility of exercise is both perpetual and American in nature. Using risk‐neutral and risk‐adjusted pricing techniques, Merton‐style options are shown to have an expected return that is a constant percentage of the option value and independent of the proximity to the critical exercise boundary. Merton options thus remain at the same point on the Security Market Line, unlike European options whose position and rate of return change dynamically. We also present formulae for the expected time and discounted times to exercise and analyse the dependency of these variables on volatility.