A General Approach to Real Option Valuation with ... - ICMA Centre

ICMA Centre Discussion Papers in Finance DP2012-04using an exponential utility – despite its tractability – because it has the unrealistic CARAproperty; (5) The price of the investment relative to the decision maker’s wealth matters: thesmaller (greater) the risk tolerance of the investor, the higher he ranks the option to investin a relatively low-priced (high-priced) asset, given that the asset-price dynamics follow thesame GBM process. Perhaps most importantly, we compare the standard RNV real optionprice with the values that would be ascribed to the option by risk-averse investors under theincomplete market assumption. Thus, we provide straightforward comparison between thereal option price that is obtained using standard, but unrealistic, assumptions with the valuethat would be found using a more complete and general approach.Our framework is sufficiently flexible to handle a variety of real options on real estate.Numerical results for different types of property investment and divestment decisions havebeen used to illustrate how our methodology can be implemented using mean-reverting or‘boom-bust’ property price scenarios. We have also shown how the ranking of various realestate options, including buying or selling a property that pays rents and investing in a fixedtermland development, depends on the investor’s initial risk tolerance and its sensitivity towealth. This research has potential applications to many other types of real options andmanagement decisions, not just to real estate problems. Also, the methodology could befurther developed in several ways: to utility functions outside the HARA class, to morecomplex views on market prices than lognormal, mean-reverting or boom-bust scenarios, andto include stochastic financing costs and/or cash flows.Copyright c○ 2012 Alexander and Chen 38