Alternative approaches for solving real-options problems

Alternative approaches for solving real-options problems

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Article ID: iaor20062385
Country: United States
Volume: 2
Issue: 2
Start Page Number: 89
End Page Number: 102
Publication Date: Jun 2005
Journal: Decision Analysis
Authors:
Abstract:

Brandao et al. describe an approach for using traditional decision analysis tools to solve real-option valuation problems. Their approach calls for a mix of discounted cash flow analysis and risk-neutral valuation methods and is implemented using Monte Carlo simulation and binomial decision trees. In this note, I critique their approach and discuss some alternative approaches for solving these kinds of problems. My criticisms and suggestions concern implementation issues as well as more fundamental issues. On implementation, I discuss the use of binomial lattices instead of trees, and alternative methods for estimating volatilities. More fundamentally, I discuss alternative approaches that rely entirely on risk-neutral valuation and model the uncertainties in the problem more directly.

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